This time of year, I hear one question a lot: “How do I fill out my tax return so that I don’t pay taxes on the money that I earned in a Combat Zone Tax Exempt (CZTE) location?” While the answer is simple, it can be confusing, so let’s dig into it a little bit.
The short and simple answer is that you don’t need to do anything. Assuming that your paperwork was right during the time you were CZTE, then your W-2 tax statement already reflects the income that is taxable and the income that is tax-exempt. Block 1 contains the amount of taxable income earned during the year, and Block 12 contains non-taxable income earned in a CZTE area next to the letter Q.
The long answer requires that you understand how our income tax process works, and the key part that withholding plays in the process. When you enter and leave a CZTE area, your unit finance folks notify the Defense Finance and Accounting Service (DFAS), and DFAS codes your income as tax-exempt, and suspends income tax withholding for the CZTE time. If you’ve given instructions for correct withholding, then your total tax liability for the year should come close to the amount you’ve had withheld, because DFAS has adjusted your withholding along the way.
Now, if your CZTE time wasn’t properly reflected in your Leave and Earnings Statements (LES) along the way, then you have an entirely different problem. Each month when you review your LES, you need to make sure that everything is right. If you’re in a tax-exempt location, that should be reflected on your LES. If DFAS didn’t get the paperwork instructing them that you were CZTE, then they can’t know not to withhold taxes, and they don’t know to mark that income as tax-exempt. If your LESes aren’t right, you need to go back to your finance unit to get that fixed. Do not file your income tax return until you get an amended W-2 reflecting the correct information.
Assuming that your W-2 is accurate, then you do not have to take any special action to reflect your CZTE income on your tax return.