Here's a look at the laws that could wage a multipronged attack on your wallet and what you can do to prepare.
Including Combat Pay May Increase Earned Income Credit and Reduce Taxes
Earned Income Credit is a tax credit for certain people who work and don't earn high incomes. A tax credit usually means more money in your pocket; the EIC can reduce the amount of tax you owe and you may also get a refund. Although certain combat pay may be nontaxable to you (See Combat Zone Exclusion in Publication 3, Armed Forces Tax Guide, for more information), you can choose to include this pay in your earned income when figuring the EIC. The amount of your nontaxable combat pay should be shown in Form(s) W-2, with code Q.
The Working Families Tax Relief Act of 2004 and the Gulf Opportunity Zone Act of 2005 give military personnel the option of treating excludable combat pay (but not BAH or BAS) as earned income for purposes of the EIC. This could help military personnel avoid a situation in which the military pay exclusion leaves them with no earned income and thus no EIC. Under this provision, military personnel may opt to include all or none of their combat pay (but not just part of it) when calculating their EIC. If you are filing a joint return and both you and your spouse received nontaxable combat pay, you can each make your own election.
Here is an example of how electing to include combat pay could increase EIC (reduce taxes).
George and Janice are married and will file a joint return. They have one qualifying child. George was in the Army and earned $11,000 ($5,000 taxable wages + $6,000 nontaxable combat pay). Janice worked part of the year and earned $2,000. Their taxable earned income and adjusted gross income are both $7,000. George and Janice qualify for the earned income credit and fill out the Earned Income Credit (EIC) Worksheet in the Form 1040A instructions and Schedule EIC. When they complete the worksheet without adding the nontaxable combat pay to their earned income, they find their credit to be $2,389. When they complete the EIC worksheet with the nontaxable combat pay added to their earned income, they find their credit to be $3,050. Because making the election will increase their EIC, they elect to add the nontaxable combat pay to their earned income for the EIC. They enter $3,050 on line 41a of their Form 1040A and enter the amount of their nontaxable combat pay on line 41b.
Here is an example of how electing to include combat pay would not increase EIC (not-reduce taxes).
The facts are the same as in the example above except George had nontaxable combat pay of $20,000. When George and Janice add their nontaxable combat pay to their earned income, they find their credit to be $2,161. Because the credit they can get if they do not add the nontaxable combat pay to their earned income is $2,389, they decide not to make the election. They enter $2,389 on line 41a of their Form 1040A.