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Military Family

Combat Pay and the Earned Income Tax Credit

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The Earned Income Tax Credit (EITC) has been a part of the tax code, in one form or the other, since 1975. According to the IRS the EITC exists, “in part to offset the burden of social security taxes and to provide an incentive to work.” Because of the numerous changes to the ETIC, the credit can be rather confusing and at times not even claimed. This is especially true of military members who deploy to combat zones. If members returning from a combat deployment are not careful preparing their taxes, they could miss the tax savings this credit provides. To help you understand the credit better I’ll outline the basics of the credit and how combat pay interacts with the credit.

What is the Earned Income Tax Credit?  As mentioned above the purpose of the EITC is to offset social security taxes and provide an incentive to work for those who are low to moderate income. I know, you’re in the military already…you have an incentive to work. So, for most folks reading this article the EITC can help offset social security taxes. And this leads to an important attribute of the credit. It is refundable. What that means is that you can potentially get more from the credit than you owe/paid in taxes. For example if your tax return showed that you should get a refund of $1,000 before the EITC and you qualify for a $1,000 EITC you will receive a total refund of $2,000 even though you may have ended up paying $0 income taxes for the year. This is not the case for most credits which stop when your tax bill gets to zero. That is how the credit offsets Social Security taxes. The criteria for qualifying for the EITC are complex (see the IRS website for complete details) but here are some basics:

  • You must have earned income (wages, tips, self-employment income)
  • You must be at least 25 and younger than 65
  • You must file as Single, Head of Household (HOH) or Married Filing Jointly (you cannot file Married Filing Singly)
  • You must have less than $3,150 in investment income (2011)
  • You must meet Adjusted Gross Income (AGI) limitations which vary based on marital status and number of dependents.  Some examples (2011 numbers) are:
    • Married Filing Jointly with 3 or more qualifying children:  $43,998 or an E-7 with up to 17 years of service
    • Single/HOH with one qualifying child:  $36,052 or an E-5 at any years of service point
    • Married Filing Jointly with no children:  $18,740 or E-1
    • Single with no children:  $13,660; no full year military member qualifies

The income/rank combinations above assume the military member was not deployed to a combat zone during the year. Some other important facts about the EITC are:

  • Unlike other credits the EITC starts low, increases as income increases and then is reduced as your income passes a certain point.  So in certain circumstances increasing your income may increase your refund!
  • The maximum EITC is substantial
    • $5,751 for 3 or more qualifying children
    • $5,113 for 2 qualifying children
    • $3,094 for 1 qualifying child
    • $464 for no children

I’ll now take a look at how a combat deployment changes things.

How does Combat Pay and EITC work?  As you probably already know, combat pay is not subject to Federal Income Tax (but it is subject to Social Security Tax and Medicare Tax). Since it isn’t reported as wages for Federal Income Tax on your W-2, your initial calculation of EITC won’t include your combat pay. In a rare sign of flexibility, the IRS allows you to choose whether to include your combat pay as earned income when you calculate the EITC. You can leave it out or add it in….but it is all or nothing. Why would you want to do that?  Well remember, the amount of the credit starts low and increases with income and then tapers off when you reach a certain point (think of it as a mesa out in the desert west). So by adding in your combat pay you may actually increase your refund. I’ll demonstrate with a couple of examples.

  • A married E-9 with 3 qualifying children whose income exceeds the threshold for the credit under normal circumstances deploys to a combat zone for 6 months and has 6 months of combat pay excluded from income: In this case, if the E-9 leaves the combat pay excluded there is a high probability that the family will earn the EITC and increase their refund.
  • A Single/HOH E-4 with 2 qualifying children deploys to a combat zone for the entire calendar year (Jan-Dec) and has all combat pay excluded from income for the entire year: No matter what the E-4 decides there will be no income tax due on the combat pay. But if the E-4 claims the EITC by choosing to include the combat pay in the EITC calculation he/she will receive a refund, potentially in the thousands of dollars, even though no income taxes were withheld. The same could potentially hold true if the E-4 deployed for fewer months during the year….depending on the exact circumstances.
  • A single or married taxpayer that wouldn’t normally qualify for the EITC deploys to a combat zone for an extended period: Like the E-9 above if the taxpayer chooses to exclude combat pay from the EITC calculation there is a high probability of earning the credit and increasing the refund.

The EITC is complicated and there are a lot of rules, especially on qualifying children, but it is a very valuable credit. If you deployed to a combat zone in 2011 there is a good possibility you may qualify for the credit…even if you never have before. It is worth it to see what the different choices in relation to your combat pay can earn you.

 

Curt Sheldon, EA is a Fee-Only Financial Planner and Enrolled Agent based in Northern Virginia.  He can be contacted at (703)542-4000, (800)928-1820 or Curt@CLSheldon.com

IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication

The information contained in this blog is for general financial education and should not be construed as individual financial advice.  Please consult your own financial, tax or legal advisor prior to applying any principles discussed here to your own financial situation.

Comments

  1. Chris

    January 18, 2012

    Combat pay should be non-taxable.

    Chris
    Owner
    Cel Financial Services

  2. Curtis (Curt) Sheldon, EA

    January 19, 2012

    Chris,

    As mentioned in the article, Combat pay is not subject to Federal Income Tax. It is excluded from Gross Income. It can however, be used to calculate the EITC, if beneficial to the servicemember.