A lot of the readers of this blog are military members or retired military members. For those who have or will retire from the military there is a potential tax issue you will need to resolve. This issue comes from the fact that VA Disability Benefits are often awarded retroactively to a prior date. To my experience, 99.99% of those us who do receive VA Disability Benefits, will receive them retroactively. And if that is the case, that means your taxes are/will be messed up. Here is what to do about your situation.
First the good news. You have the right to reduce your military retirement income by the amount that your pay should have been reduced if your VA Disability Benefits would have started on time. This right was established by the courts in the Strickland decision (Strickland v Commissioner, 4th Cir. 1976) and is codified in Revenue Rule 78-161. That is about the end of the good news.
Now, the bad news. You are going to get little to no “automatic” help to do this. You won’t receive and updated 1099-R. You might get a note from the VA saying that you have rights under the Strickland Decision. You won’t get a notice from the IRS letting you know you overstated your income in a prior year due to the VA offset not being taken. So, you are going to have to do this yourself or bring in a pro from Dover.
What needs to be done?
If you were awarded retroactive VA benefits in 2011 you will need to adjust the amount on your 1099-R by the reduction that should have occurred and use the adjusted amount on your tax return. If you are like me, you’ll need to do two separate calculations, as I had to prove my sons were in college to get an increase in the Disability payment amount. So I had a period where the offset was correct, a period where the offset was too little and a period of where there was no offset. Now, when you file your return you’ll have to decide whether you want to e-file or not. I’m not 100% sure, but I think your return will go through. But your 1099-R and your tax return won’t agree and this could trigger an audit or at least some questions. The other option is to file on paper, include a letter explaining that you reduced your 1099-R income IAW Rev Rul 78-161 and also include a copy of the letter from the VA establishing your retroactive benefits (including your 214 might not hurt either). Easy, right?
If your retroactive benefits span two years (for example you retired in 2010 and didn’t get a determination until 2011) you’ll have to decide if it is worth your time to try to get the refund that is probably due. If you are rated more than 50% disabled, the tax benefit may be small and you might want to just let it go (you could send a letter to the President and let him know you did your part to reduce the deficit…sorry, editorial comment there). If you are rated less than 50% disabled it may be worth your time. What you will do in this case is file an IRS Form 1040X (amended tax return) changing your retirement income to reflect the offset that should have been taken. Then include all the documentation mentioned above. Even easier…
So the bottom line is: when you get retroactive VA Disability Benefits, you have the right to retroactively reduce your income. But you’re going to have to do it yourself or hire someone to do it for you.