Written by: Barbara O’Neill, Ph.D., CFP® and Martie Gillen, Ph.D., MBA, AFC®, CFLE
Personal Finance Managers routinely answer questions from clients about income taxes. While January through April is considered “tax season,” May through December is the time for tax planning. A key thing service members need to know is the types of income and how they are taxed.
Below is some “need to know” information to share with military families:
Marginal Tax Brackets- There are currently seven federal marginal tax brackets ranging from 10% to 37%. The word “marginal” indicates tax paid on the last dollar of income. Like a layer cake, ranges of taxable income are stacked on top of each other and taxed at different rates. For example, a military family may pay 10% on an initial portion of their income, 12% on the next income increment, and 22% on their final dollar.
Non-Taxable Allowances– Some income received by service members is exempt from federal and state income tax including the Basic Allowance for Housing (BAH), the Basic Allowance for Subsistence (BAS), and most other allowances (exception: Conus COLA). This is significant because BAH and BAS average over 30% of regular pay according to the Department of Defense. They are also excluded from FICA (Social Security) tax.
Other Non-Taxable Income– Income earned during active duty service in a combat zone is excluded from taxation as is the $100,000 death gratuity paid to survivors of deceased service members. Education and training benefit payments for veterans are also tax-free and some states exclude military retirement pay from income.
Ordinary Income– This income is taxed at the tax rates noted above. It includes military pay (excluding allowances), a spouse’s employment income, “side hustle” income, rental income (e.g., service members who become “accidental landlords”), and interest on bank accounts and certificates of deposit. For older veterans, income from Social Security, withdrawals from the thrift savings plan and traditional IRAs, and military retirement pay are taxable as ordinary income.
Capital Gains Income- Income generated from profit on the sale of investments held for a year and a day or longer is taxed at favorable long-term capital gains tax rates ranging from 0% to 20%. Examples include gains upon selling individual stocks, mutual funds, or exchange-traded funds held in taxable (non-retirement plan) accounts. Short-term gains on investments held for one year or less are taxed as ordinary income.
Dividend Income– Qualified dividends that meet specific IRS criteria are taxed in a similar manner to long-term capital gains with a top rate of 20%. Several exceptions apply. Investment custodians report whether dividends are ordinary or qualified dividends on 1099-DIV forms sent to investors. As the name implies, ordinary dividends are taxed as regular income.
For additional information, review the OneOp blog post Income Tax Planning Tips for 2023.
Photo by RomanR on Adobe Stock_192878728
