Taxes and the Military Retiree

One of the many benefits I encountered while serving in the military was to remain blissfully ignorant about income taxes. Serving in the military presents some unique tax advantages due to the way service members are compensated. Even with additional income from real estate and mutual fund investing, over the course of my career, our effective tax rate remained relatively low. We received a small refund every year.

For many veterans, taxes increase dramatically when we return to civilian life and gain employment while simultaneously earning a military pension. Having to pay more taxes means earning more money which is never a bad problem to have!

But what does this really mean for the working veteran and how can he or she prepare for the likely inevitable increase on the tax bill? I’ll share three things I learned as I prepared taxes for my first full year back as a civilian.

Disclaimer upfront, I am not a tax professional! These are simply my observations as a recently retired veteran on income taxes. I can’t recommend strongly enough to seek professional tax advice if transitioning out of the military!

1. Federal income tax withholding. As I began my civilian employment, I claimed only myself and spouse on my federal tax W4 form. I left my two children off thinking that should allow for adequate withholding. Since I retired towards the end of 2019, I only received a few civilian employer paychecks but it was enough to make a surprising discovery when preparing our 2019 return!

I realized I was going to be severely under paid for tax year 2020. What I learned, and what I’m sure most civilians probably already know, is that withholding is based on the compensation for that particular job.

If the employee has other sources of income such as military retirement, they could very well be in a higher tax bracket! As stated, this is a good problem to have, but it must be prepared for. About mid-year 2020 I adjusted my W4 so that my employer took out additional withhold.

Another option would have been to withhold at the single rate. Military retirees can also increase withhold from their retirement check if that’s a better option. I think for now, I’ll just keep the additional withhold as I can more easily manage.

Thankfully we came in just about even on our 2020 federal tax return, just the way I like it!

2. State Income Taxes. Another tax “benefit” of military service is that service members can claim just about any state of residence while serving. I claimed my home state of Tennessee for 24 years. Tennessee is one of the few remaining states without an income tax.

But when veterans retire from service, they usually must become legal residents of the state in which they will be working. The state we landed in has an income tax. It was a sad day when I “renounced” my Tennessee citizenship and got a driver’s license for my new home state!

Based on a co-worker’s recommendation, I claimed zero dependents on my state W4 so they would take out max withholding. Not going to lie, it stung a little bit seeing both federal and state tax withholding going out every pay period! Thankfully, my new home state does not tax military retirement.

As I prepared my 2020 state income tax return using a popular tax preparation software, I noticed many similarities to the federal return but also some distinct differences. One of the biggest differences is my state lets taxpayers “double dip” on investment property depreciation.

This simply means one can deduct depreciation of the investment property twice, once from the gross rental income on the property which reduces taxable income. Then again as an itemized deduction for the “depreciation of an investment property”.

“Double dipping” on depreciation used to be the case on federal returns. Unfortunately, federal tax law changed a few years ago and depreciation of investment properties are now only deducted once. Regardless, as I noted in my blog a few weeks ago, tax advantages are another reason to love real estate!

Because my state still permits rental property depreciation double dipping, our itemized deductions were substantial which reduced state taxable income. Bottom line, I over paid significantly on my state taxes and will receive a big refund!

Certainly don’t mind the refund, but prefer to come in “on time” when it comes to income taxes. I promptly adjusted my state W4 to reflect actual number of dependents in order to reduce state withholding each pay period.

If I had just taken the time to learn a little more about state income taxes before winging it, I could have used those funds I overpaid in taxes to invest!

3. Reducing taxable income. Many military members take part in the Thrift Savings Plan which is the government’s version of a 401k. Most veterans understand contributions to a 401k are pre-tax and reduce taxable income.

But as I learned last year, with multiple income streams post military retirement, I had to get savvy about other ways to reduce taxable income. In addition to maxing out 401k contributions, there are other employer pre-tax deductions such as insurance premiums and health savings account contributions.

I took advantage of the health flexible spending account contributions in 2020 and it certainly helped. We also increased our charitable giving which helped out our itemized deductions.

Mortgage interest is another substantial itemized deduction. Before paying off a mortgage, I would definitely weigh tax benefits of the interest deduction (and retaining capital to invest elsewhere) versus not making a monthly mortgage payment.

As I pointed out in the “Another Reason to Love Real Estate Investing” blog, the income from our real estate investments was also tax advantaged for 2020 as it is every year.

I never gave much thought while serving to find creative (and legal) ways to decrease taxable income. Now as a civilian again, to not do so is very costly!

These were my three big takeaways after my first full tax year back as a civilian. I am sure I’ll have many more in the years to come. My only regret, learning about taxes the hard way instead of seeking out professional help as I transitioned from the military!

We’ve refinanced three properties in the past six months! Next week I’ll share some thoughts on refinancing.

The commentary provided in this blog is for informational purposes only and is not intended to be a source of financial, tax or investing advice.

The views, opinions and biases expressed in this blog are the authors and do not reflect those of the U.S. Army or the Department of Defense.

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