Tax Considerations in a Combat Zone

On Mondays, I discuss financial considerations that specifically relate to US service members. If you have any questions or topics you’d like to see discussed, please leave a note in the comments or email me at MilitaryDollar@militarydollar.com.

What is a CZTE?

CZTE stands for Combat Zone Tax Exclusion. CZTEs are areas that POTUS designates by Executive Order as an area in which the US Armed Forces are engaging in combat. You can find the complete list of current CZTEs here. I always check the IRS website for the most current list. Sometimes, if you look somewhere else, you are looking at an old list. Don’t let this easy mistake affect your financial planning.

Earnings received while in the combat zone are excluded from federal income tax. You don’t have to be in the combat zone the entire month to receive the tax exclusion.   If you serve in a combat zone for any part of one or more days during a particular month, you are entitled to combat pay exclusion for the entire month. You can also be given the tax exclusion for military service performed outside a combat zone which the DOD designates is in direct support of military operations inside the combat zone if you are also qualified for hostile fire or imminent danger pay.

Tax-Free Pay

There is a slight misunderstanding out there that says basic pay is tax-free in a combat zone. That’s not 100% true. Don’t worry. The exception doesn’t affect the majority of deployers. But, for the sake of completeness, here it is:

For enlisted members and warrant officers, none of the basic pay you receive while in a CZTE will be taxed. If you are a commissioned officer (other than a commissioned warrant officer), there is a limit to the amount of combat pay you can exclude. Your excluded pay is limited to the highest rate of enlisted pay plus imminent danger/hostile fire pay. For 2017, the applicable amount is $8,390.10 per month ($8,165.10 for the highest enlisted pay + $225 for imminent danger pay). That means anybody who is lower ranking/has less years than an O-5 with over 18 years Time In Service should have their basic pay treated as non-taxable income.

Everybody’s taxes are different, of course, but basically this means that your tax benefit is a couple hundred to potentially $2,000 or more each month you are in a CZTE.

Bonuses and Special Pays

You can also get a tax exclusion for bonuses and special pays received while serving in a CZTE. Just remember they follow the same rules listed above (for officers, pay attention to the income limits).

You’ve probably heard of someone getting an enlisted reenlistment bonus while deployed and being stoked that they won’t have to pay taxes on it. That opportunity can make a huge difference in the taxes owed for the bonus. Since there is no limitation on amounts excluded for enlisted members, the entire reenlistment bonus would be excluded.

An officer’s flight pay is also excluded from taxable income, but only up to the point which basic pay and the flight pay do not exceed the maximum enlisted pay amount ($8,390.10 per month in 2017). Other special pays which are excluded while in a CZTE are:

• medical or dental pay
• special assignment pay
• hardship duty pay
• foreign language pay
• sea pay

Funding Retirement Accounts While in a Combat Zone Tax Exclusion

If you are familiar with the difference between Traditional and Roth tax treatments on retirement accounts, you might think you should automatically use Roth accounts whenever you deploy to a CZTE. It makes sense, right? Your income isn’t taxed because you are in a CZTE. Additionally, your withdrawals won’t be taxed because it is a Roth account. AWESOME, RIGHT?!

(Not familiar with Traditional and Roth tax treatments? Click here for a brief overview and stay tuned for a detailed explanation on Friday!)

But, as with many things, the answer is actually “it depends.”

If you will be investing no more than the normal contribution limits ($5,500/year for IRAs and $18,000/year for TSP in 2017) you should probably go with the Roth. You get double the tax benefits. Easy!

Note: The normal contribution limit in TSP is known as the “Elective Deferral Limit”

Annual Addition Limit Rules

But if you can contribute more, there is something called the “Annual Addition Limit.” This limit allows you to contribute up to $54,000 total to TSP when contributions are made from a CZTE.

If you are already maxing out an IRA and the elective deferral limit for the TSP while deployed to a CZTE and you have more money to contribute (lucky you!), you can invest up to $36,000 more ($54,000 total) into a Traditional TSP account only. You won’t get double tax benefits on that $36,000, but you will get the rare opportunity to contribute up to three years worth of normal contributions in a single year.

From the TSP.gov website:

If you are a member of the uniformed services, you should know that Roth contributions are subject to the elective deferral limit ($18,000 for 2017) even if they are contributed from tax-exempt pay. If you want to contribute tax-exempt pay toward the annual additions limit, you will have to elect traditional contributions for any amount over the elective deferral limit.

How would that work?

Step one would be to max out your Roth IRA and put $18,000 in a Roth TSP account. Doing both of these things before adding more to a Traditional TSP allows you to maximize your tax benefits. Then, if you can, change your TSP contributions from Roth to Traditional and contribute up to an additional $36,000.

If you are not deployed at the beginning of the calendar year, consider funding Traditional TSP until you arrive in the CZTE. Once you arrive in the combat zone, start maxing out the Roth IRA and Roth TSP. That enables you to get the maximum tax benefits. You can switch back to Traditional TSP contributions once you hit the $18,000 limit for Roth TSP.

Consider carefully whether you want to contribute any extra money you have (above the $18,000 elective deferral limit for the Roth TSP and $5,500 for a Roth IRA) to the Traditional TSP, up to the $54,000 limit. On one hand, this is a fantastic way to put extra money into a retirement account. Having it in a retirement account is a great way to force you to keep your hands off the money! However, if you have the self-discipline not to cash out the account, you might want to put any extra money into a taxable account instead.

Why? Taxes, naturally. Money you contribute to a Traditional TSP account will be taxed at your federal income tax rate when you withdraw it. Money you withdraw from a taxable account, on the other hand, is taxed at a lower long-term capital gains tax rate if you keep it in the investment for over a year. For instance, if you are in the 15% income tax bracket in retirement you would be able to pull the money out with 0% capital gains in retirement (using 2017 tax rules). If you are in the 25% tax bracket, you would pay 15% in capital gains. Weigh the tax benefits against your self-discipline and make the best choice for your situation.

Points to Remember

• These deployment considerations are specific to when you are in a CZTE. If you aren’t deployed at the beginning of the year, your contribution decisions, including when to make contributions, may change. Work with a tax professional or knowledgeable financial advisor to figure out the best plan for your situation.
• Don’t screw up your timing! Pay attention to when you will reach the $18,000 elective deferral limit for Roth contributions. You want to change your TSP contributions to Traditional before you go over $18,000.

Reminder: I am not a financial planning professional. All information presented on this blog is for informational purposes only and should not be mistaken for financial advice. Read my full disclaimer here and contact a certified financial planner if you have any questions.

Have you taken advantage of the tax exclusions in a CZTE? Tell us your story!