You can recoup the taxes DFAS withheld on your disability severance pay. Unfortunately the process is a bit involved, but remember this involves both DFAS and the IRS.

If you receive a lump-sum disability severance payment and are later awarded VA disability benefits, you can exclude 100% of the severance benefit from your income  (under the provisions of 26 USC 104, see also Publication 17 (2015), Your Federal Income Tax).

In order for the money to become tax-free, you must have a VA rating for the same disability that led to your separation.

There are TWO ways to get your money back, but you must make sure you use the right one...

1. You can get the money back from DFAS if you act in time. You do this by calling the Separation and Reenlistment Division at DSN 699-7731/7027/6129/6142 or commercial 317-510-7731/7027/6129/6142. However, this can ONLY be done before 31 December in the year you receive the severance payment, but no sooner than 20 business days of receiving payment. After December 31, the taxed money goes to the IRS, so you must use option number 2.

2. If you did not meet the deadline in the above option, then you request the tax money back from the IRS. If you haven’t filed your tax return for the year in which you received the disability severance, you can make the correction on the current tax return. If you have already filed your tax return for the year in which you received the disability severance, you will have to file an amended return. You have three years from the date the original return was due (including extensions) or filed (if later than the due date) to amend your return. In both cases, you enter the correction in the same place.

Go to the Other Reportable Income interview, the very last interview in Wages and Income (Federal Taxes tab > Wages & Income category > Less Common Income subcategory > Miscellaneous Income sub-subcategory). Enter the full amount of your severance pay (i.e. not reduced by the income taxes withheld) as a negative number (use "minus" sign).

This will tell the IRS that you are subtracting that amount from your income. Describe the entry as Military Severance Reclassified as Disability (see sample screenshot).

You MUST send in the supporting documentation listed below, with your return. If correcting this in the same tax year the payment was received, you will have to print and file the tax return by mail; amended returns always have to be mailed.

Paperwork you will need for either option.

·  Unless this is the first tax filing since getting the severance pay, you need to include a copy of the Individual Federal Tax Return for the year in which you received your severance pay. 

· Original IRS Form W-2 (some say you can get a corrected W-2 from DFAS, but that is either not possible or not worth the effort or delay).) 

· VA award documentation 

· Separation orders 

· DD Form 214 stating your severance pay amount before taxes

If you are amending a prior year return, include a cover letter ("St. Clair" letter). A sample format is attached. 

 Send copies with your return to the IRS; send certified mail, return receipt requested to the address listed in your TurboTax filing instructions.

(If you encounter any issues, please update this post with a "Comment" and provide details).

Finally, if you are amending for previous tax years, don't forget your state returns - they probably have some of your money, too!