Disability severance pay taxed

[ToddL]

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 (in parentheses)

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)

[akphoneguy]

Is this still current information?  and where do these entries show on the 1040?

[MonikaK1]

The 2024 version of Publication 17 still has the information as shown below. The procedure to report negative income in TurboTax is still the same as shown in the 2019 post to which you referred (Other Reportable Income).

If you receive a disability pension based on years of service, in most cases you must include it in your income. However, if the pension qualifies for the exclusion for a service-connected disability (discussed earlier), don’t include in income the part of your pension that you would have received if the pension had been based on a percentage of disability. You must include the rest of your pension in your income.

Retroactive VA determination.

If you retire from the armed services based on years of service and are later given a retroactive service-connected disability rating by the VA, your retirement pay for the retroactive period is excluded from income up to the amount of VA disability benefits you would have been entitled to receive. You can claim a refund of any tax paid on the excludable amount (subject to the statute of limitations) by filing an amended return on Form 1040-X for each previous year during the retroactive period. You must include with each Form 1040-X a copy of the official VA determination letter granting the retroactive benefit. The letter must show the amount withheld and the effective date of the benefit.

If you receive a lump-sum disability severance payment and are later awarded VA disability benefits, exclude 100% of the severance benefit from your income. However, you must include in your income any lump-sum readjustment or other nondisability severance payment you received on release from active duty, even if you’re later given a retroactive disability rating by the VA.

Special period of limitation.

In most cases, under the period of limitation, a claim for credit or refund must be filed within 3 years from the time a return was filed or 2 years from the time the tax was paid. However, if you receive a retroactive service-connected disability rating determination, the period of limitation is extended by a 1-year period beginning on the date of the determination. This 1-year extended period applies to claims for credit or refund filed after June 17, 2008, and doesn’t apply to any tax year that began more than 5 years before the date of the determination.

@akphoneguy 

[akphoneguy]

While the info is ‘correct’ the mechanism is flawed. While the military LES may show a difference between disability award and payout, that isn’t a solid tax document to do the corrective action on the tax return. Some who exit the military have the DD214 clearly showing the withholding for taxes, but not all.  Apparently DOD doesn’t bother to determine which departing service members’ medical severance award would be taxable or not and, typically, are withholding taxes from all.  DOD also has a mechanism for requesting repayment by DOD, but with time constraints (15 Dec of the year of payment.  That may work whose awards are received earlier in the calendar year, but not for those who get their payment late in the year.

What other documents have TT users had clearly showing the withholding to support the recovery via the tax return.

[MonikaK1]

I can't speak for other users with this situation, but if you report all of the income that is shown on information returns (W-2 and 1099) issued to you, then the IRS matching program will not find a discrepancy even if you separately report the appropriate amount to be excluded as a negative amount under Other Reportable Income.

Your local veterans services office may have more information on this topic.

@akphoneguy