In a Nutshell
Military members who serve in a combat zone may be eligible for multiple tax benefits. These include the Combat Zone Tax Exclusion, which allows service people to exclude certain types of combat pay from their federal taxable income.This article was fact-checked by our editors and CPA Janet Murphy, senior product specialist with Credit Karma. It has been updated for the 2020 tax year.
While excluding your combat zone pay can lower your taxable income, in some cases you might not want to take the exclusion.
The Combat Zone Tax Exclusion (or CZTE) dates back to World War I, when taxes were increased to pay for the war effort, and the government decided that members of the armed forces should be exempt from the increase. It’s one of many tax-related benefits the IRS extends to military members.
The CZTE works a little differently today, but the exclusion can still offer significant tax savings to military members and their families.
- Qualifying for the CZTE
- Taking the tax exclusion
- Additional tax benefits for military members in combat zones
Qualifying for the CZTE
Whether you can qualify for the Combat Zone Tax Exclusion — and if you qualify, how much pay you can exclude — can depend on your rank, where you’re serving and the type of income you receive.
Who’s eligible?
Enlisted military members, warrant officers and commissioned warrant officers participating in military operations in a combat zone may be eligible for the CZTE, and there’s no cap on how much combat pay they can exclude from their taxable income.
On the other hand, there is a monthly cap for commissioned officers serving in a combat zone that depends on the highest rate of enlisted pay, plus imminent danger or hostile fire pay.
What counts as “serving in a combat zone?”
You can qualify as serving in a combat zone in several scenarios, including situations when you aren’t physically stationed in a combat zone.
Your pay may be eligible for the CZTE if you qualify for hostile fire or imminent danger pay, or you have an official temporary duty assignment and …
● You’re serving in an area that’s designated as a combat zone by a presidential executive order.
● You’re in an area that the Department of Defense designated as directly supporting a qualifying combat zone operation.
For example, (as of Nov. 15, 2020) your pay could qualify for a tax exclusion if you’re serving in the Sinai Peninsula or Afghanistan, as well as some other locations.
The IRS maintains a page with a current list of areas that qualify as combat zones for tax purposes.
What counts as taxable income?What type of pay qualifies?
The CZTE can apply to several types of income. You need to receive the income while you’re in a qualifying area, or the event that leads to the income must occur while you’re in a qualifying area. Here are the types of pay that qualify.
- Active-duty pay while you’re serving in a combat zone.
- Extra pay (capped at an extra $225 per month for commissioned officers) you receive for being in imminent danger or under hostile fire while you’re serving in a combat zone.
- Re-enlistment bonuses or bonuses for voluntarily extending your service if your new service period begins while you’re serving in a combat zone.
- Leave pay, if your unused leave was accrued while you were serving in a combat zone.
- Income from working in a club, mess, post or theater, or from duties for nonappropriated fund activities, while serving in a combat zone.
- Awards from submitting a suggestion, invention or scientific achievement while serving in a combat zone.
- Student loan repayment assistance funds (the excluded amount is prorated to match the number of months you served in a combat zone).
“If you’re [serving] in a combat zone for one day, that whole month is considered combat exclusion,” says Kristen Morgan, an IRS-registered tax preparer who frequently works with military members.
You are also considered as eligible while hospitalized, missing in action or a prisoner of war as a result of your service in a combat zone. However, if you fly over a combat zone, are in a combat zone while on leave or decide to visit a combat zone, those periods won’t count as serving in a combat zone for tax purposes.
Taking the tax exclusion
Generally, if you qualify for an income exclusion, you don’t need to do anything special. The W-2 you receive should have the excluded income in box 12 of your Form W-2 with a Q next to it.
Compare your tax return with and without the exclusion
If you want, you’re allowed to include the CZTE-qualifying income as taxable income. At first glance, it may not make sense to do so, but increasing your taxable income might help you qualify for the Earned Income Tax Credit.
When taking the EITC, you must include all or none of your combat pay. However, if you’re filing a joint return and your spouse also has combat pay, you can choose to only include one spouse’s otherwise-nontaxable income.
“You should prepare your return [both] with combat pay and excluding combat pay,” says Morgan. “With combat pay, you can include it in your taxable pay for earned income tax credit reasons.”
After comparing the results, you can file using whichever scenario leads to a higher return.
The impact on retirement contributions
Your nontaxable combat pay still counts as compensation when you’re trying to determine your eligibility for traditional and Roth IRA contributions, limits and deductions.
Serving in a combat zone can also impact your Thrift Savings Plan contribution limits. In 2020 and 2021, there is a $19,500 annual limit for contributions to traditional and Roth TSP accounts.
If you’re receiving nontaxable CZTE income, the limit doesn’t apply to traditional TSP contributions you make with that tax-exempt combat pay. However, the combined annual limit for employee and employer contributions still applies.
Responding to an IRS inquiry letter
If you claimed the CZTE, you may receive a letter from the IRS asking for proof that you were deployed in a combat zone. Morgan says it happened to two of her clients last year.
“Don’t panic; just fill the form out and send it back,” she says. “The IRS just wants to verify that people are filing properly.”
FAST FACTS
Why you might get a letter from the IRS
A letter from the IRS isn’t always a warning that you’re being audited. You might get a notice or letter for several other reasons, including …
You owe tax, interest, penalties or all three.
Your refund will be larger or smaller than you expected.
The IRS has a question about the return you filed.
The agency needs additional information about your return.
The IRS needs to verify your identity.
The agency made changes or corrections to your return.
There’s a delay in processing your return.
Learn more about letters from the IRS and how to handle them here.
Additional tax benefits for military members in combat zones
Automatic extensions
Military members serving in a combat zone have more time to file their taxes.
Instead of the April 15 deadline, service people in combat zones must file their returns 180 days after they leave the combat zone, end qualifying service outside the combat zone, or end their service in a contingency operation. If you’re injured while serving in a combat zone, qualifying service or contingency operation, you have 180 days after leaving the hospital in which to file.
You may also get additional time. Your filing deadline can be extended by the number of days you had left to file before you began serving in the combat zone. For example, if you started serving in the combat zone on January 15 and would have filed on April 15, those three months will be added to your 180-day extension when you leave the combat zone.
The extension applies to multiple tax-related events, including tax payments, IRA contributions and even IRS collection actions.
Free tax-preparation assistance
Military members serving in and out of combat zones get access to free tax-preparation software (Military OnceSource MilTax) and in-person tax-preparation services with specially trained tax preparers through the Volunteer Income Tax Assistance location in a military installation.
If you plan to prepare and file a joint tax return while you or a spouse is in a combat zone, the deployed person may want to sign an IRS Form 2848 and grant the spouse filing the return power of attorney to sign the tax return. Although, if the deployed spouse is in a combat zone, a written statement describing the situation from the filing person may suffice.
Unpaid tax forgiveness
If during active-duty service in a combat zone a military service member is fatally injured or falls fatally ill, their unpaid taxes for the year are forgiven, according to the IRS Armed Forces Tax Guide. The forgiveness can also apply to prior years that ended after the combat zone service began. The service member’s beneficiary or trustee won’t have to pay tax on the forgiven income, either.
Bottom line
Among other potential benefits, military service members may not have to pay federal income taxes on some of their income while serving in a combat zone or in an area supporting a combat zone. The exclusion can lead to significant tax savings, particularly if you receive a large bonus during a qualifying period. However, as is often the case with tax situations, you’ll want to compare your return with and without the exclusion before filing to see what benefits you most.
A senior product specialist with Credit Karma, Janet Murphy is a CPA with more than a decade in the tax industry. She’s worked as a tax analyst, tax product development manager and tax accountant. She has accounting degrees and certifications from Clemson University and the U.S. Career Institute. You can find her on LinkedIn.