Several people have asked me to write about how your income tax changes when you retire from the military. On one hand, it is pretty simple. On the other hand, if you haven't thought it through completely, it might be surprising. There are two different tax issues you need to consider.
Adjust Your EstimatesOne of the benefits of military service is that a significant portion of your total military compensation (all the money you bring home) is non-taxable. Generally speaking, pays are taxable and allowances are non-taxable. Basic Allowance for Housing (BAH) is non-taxable, as is Basic Allowance for Subsistence (BAS) and Cost of Living Allowance (COLA).
Depending on your rank, time-in-service, location, and dependency status, these allowances can make up anywhere from 15% to 50% of your income. Not paying taxes on that much of your income can give you a false sense of what percentage of taxes you're paying compared to your income. Let's say you are making $48,000 a year in taxable pay, and you get $24,000 a year in non-taxable allowances, totalling $72,000 per year. On that total pay and allowances, you are paying $6,000 a year in federal income taxes. You retire at 20 years of service and you know that you'll be earning $24,000 in military retirement pay. Some people look at these numbers and think that since they're bringing home 1/3 as much money, they'll only pay 1/3 as much taxes, or $2,000 per year. In reality, they'll be paying 1/2 the previous amount of taxes, or $3,000 per year.
These figures are completely hypothetical, but they illustrate the problem. If you don't account for the fact that a large portion of your military compensation is non-taxable, then you may have a misunderstanding about how much you'll need to pay in taxes on your retirement pay.
Adjust Your WithholdingThe other major retirement tax issues comes up if you pursue a second career. If you are receiving military retirement pay, and a regular paycheck, you need to be sure that you have enough money taken out of each paycheck to pay for the tax bill. If you just fill out the regular withholding exemption worksheet, and you don't mark down military retirement pay as another income, you'll be under-withholding at your new job. If you don't go back to the Defense Finance and Accounting Service and adjust the withholding on your military retirement pay when you secure the new job, you'll have too little taken out of your retirement pay, too. Many retirees report that they significantly under-withheld the first year of retirement because they were treating the two sources of income separately.
The corollary to this situation is when a spouse starts working after the military member retires. Assuming that you are filing your income taxes jointly, the withholding for each person needs to reflect your entire tax situation. Many military spouses start a new career in the same time frame that their husband or wife leaves active duty. The addition of this new income requires an adjustment on the withholding on all income to increase the chances that you'll get it right (or as close as possible.)
Don't let those first years of retirement be spoiled by tax surprises. Think critically about how retirement will affect your total tax liability, and take the necessary action to withhold the right amount from the start. Your tax-time self will say "thank you."