I’ve read quite a few questions lately from recent retirees who are confused about their state of legal residency, and where they need to file their state income taxes. State of legal residence for retirees is an important issue, and ideally you are thinking about it long before you actually retire, and definitely while you are planning your post-military life.
Active duty military members are permitted to retain their state of legal residence even when Permanent Change of Station (PCS) orders require them to live elsewhere. This protection comes from the Servicemembers Civil Relief Act. Military spouses, depending on their situation, may be able to retain their state of legal residence as they move with their active duty service member. This protection comes from the Military Spouses Residency Relief Act.
Once the service member retires, both partners lose these protections, and must follow the same residency rules as civilians. This generally means that they have to pay state income tax to the state in which they actually reside. That can be a big shock, especially if they’ve been legal residents of a state with no state income tax. With state income tax rates running as high as 13.3% (for the highest tax bracket in California), not planning for state income taxes can be a big shock. Even with a relatively average rate of 7-8%, we’re talking about some significant money. Depending on the state, retired military members may be paying on taxes on their military retirement pay, any investment or other income, and/or pay from their second career.
Another surprise is how much of total military compensation is non-taxable. Only pays, such as base pay and special pays, are taxable. Allowances, such as housing allowance, are non-taxable. What this means is that even if you’re making the same total amount of compensation from your retirement job as you made from your active duty job, you may well be paying significantly more taxes on it.
So, what can a prospective (or recent) retiree do? Most importantly, be aware of the tax consequences of the choices you make with regard to where you work and live. Be sure that you are factoring in all the variables, including which sources of income are taxed in your desired state, and the cost of those state taxes.
Once you make a decision about where you’re going to put down roots, be sure that each payer, including new jobs and the Defense Finance and Accounting Service (DFAS) has the correct state and federal tax withholding information so that you aren’t stuck with a huge bill at the end of the tax year. I’ve heard many recent retirees report that they forgot to change their state withholding with DFAS and it was a tax-time hassle.