For Ex-Servicemembers, Extra Paycheck = Higher Taxes?

Who wouldn’t want an extra paycheck every year? For millions of retirees that wish is about to come true, but not without some potential problems with the IRS.

The news came in the form of a press release from the Department of Defense, which announced on Tuesday that it will change some dates when former soldiers receive their retirement pay and other benefits. Generally, the department cuts paychecks on the first day of every month. In the past, if the first day of the month fell on a weekend or holiday, the government would wait until the next business day to cut checks.

For 2011, that means two paydays will change. Checks scheduled for Oct. 3 will actually go out on Sept. 30, and those scheduled for Jan. 3, 2012 will be cut on Dec. 30, 2011. That’s mostly good news, especially for retired soldiers who have student loans, payday loans, or other types of loans set up for automatic withdrawal from their bank accounts, says Katie Savant, government relations director for the National Military Family Association.

“It’s trying to make sure they have their payments on the first day of the month,” Savant says. “This is something that will benefit them.”

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But the change could also mean an increased tax burden, points out Joe Morrin, senior vice president of financial planning at First Command, a financial services company that caters to military families. Moving the January payment back into December means that retirees will receive 13 checks in 2011 instead of their normal 12, which means an 8.3% increase in taxable income.

The thirteenth check should be taxed like all the rest, Morrin says. But retirees should check with an accountant or financial planner just in case the additional income is enough to push them into a higher tax bracket, in which case they might get penalized for underpaying.

The extra paycheck for 2012 could also increase the amount of Social Security benefits that are subject to taxation, Morrin says, which makes it even more important that retirees check in with their financial planners about the change.

“One concern is the potential underpayment penalty,” Morrin said in comments emailed to Credit.com. “This is particularly important for those who had an amount due on this year’s return and have not adjusted their withholdings.”

Another concern could be retirees’ Roth IRAs. Annual contributions to such retirement accounts are limited by the IRS.

The extra paycheck for 2011 could put military retirees over those limits. If they do go over, they could be hit with an extra tax. Retirees should also make sure that their eleven paychecks in 2012 are enough to satisfy their IRA savings goals, or whether they should plan to contribute more next year.

“They should check to make sure they will not be ineligible to contribute,” Morrin says. “Ineligible contributions already made will need to be backed out to avoid an excise tax.”

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