Which State Will You Choose? New 2023 Tax Filing Option for Military Families

Which state have you decided on for your 2023 state income taxes? As a military service member or spouse, your options may have changed since you filed your 2022 taxes. Importantly, your state tax laws may not have caught up, but a new federal law supersedes state laws, so you should know what you can and cannot do.

The Veterans Auto and Education Improvement Act of 2022 became law in January 2023. It gives both service members and their spouses more options in terms of where to pay state income taxes.

Big note up-front: Every situation is different. Just because a law appears to apply to you doesn't mean it actually applies to you. If you're unsure, confirm with your installation's legal office, a tax professional or the state(s) in question.

Legal Residence for Service Members

A service member's state of legal residence matters less under the new law, but it still represents one option for paying state taxes.

For many decades, the Servicemembers Civil Relief Act has allowed service members to retain their preexisting state of legal residence after relocating on permanent change-of-station (PCS) orders. Now, under the new law, that's still true, and most people understand how it works: Because they're keeping their legal residence, they can file state taxes in that state.

After PCSing, they could, and still can, also choose to establish legal residence in their new state, according to the state's rules, then notify the military's Defense Finance and Accounting Service that they've done so and start paying that state's taxes (or not paying any state taxes in states without any).

Legal Residence for Military Spouses

Military spouses' state of legal residence was historically a little trickier, and figuring out where to file resulted in a lot of unintentional rule-breaking.

Before the enactment of the 2022 law, spouses could retain their prior state of legal residence after PCSing -- but only if the service member did, too. Spouses also had the option to pay taxes and vote in their active-duty service member's state of legal residence, even if the spouse wasn't a legal resident there.

To make matters more confusing, several states had laws allowing military spouses to change their state of legal residence, even if the service member did not.

Under the new federal law, military spouses may now retain their state of legal residence, even if it is not the same state as their service member's.

Tax Protections Under the New Law

Under the Veterans Auto and Education Improvement Act, service members and their spouses have a choice of states that they can elect for purposes of state income taxation. The choices include:

• The legal residence of the service member
• The legal residence of the military spouse
• The state where the service member is stationed

How States Have Responded

Typically, when a new federal law goes into effect, the states adjust their paperwork to reflect the new law. They might even change their own laws to match, but the federal law trumps the state law if they don't agree.

So far, many states have not updated their forms, regulations and instructions to reflect this new law. For example, the Virginia Department of Taxation Military Spouses Residency Relief Act webpage still outlines several situations in which it says taxes are owed to Virginia. These examples are not in line with the new federal law.

(A side note: "Military Spouses Residency Relief Act" is an obsolete name for this type of legislation. First, because the original, federal MSRRA simply modified the Servicemembers Civil Relief Act. Second, because that law has now been superseded several times. While you may still hear people use the term when talking about military spouse residency and taxes, it's not accurate. And it might cause confusion.)

What's Not Covered

Two important items are not provided for in the 2022 bill, nor any previous bill.

First, neither service members nor their spouses can choose a state of legal residence -- residency entails more than just taxes -- without meeting that state's requirements to be a resident. In almost all cases, that includes a physical presence in that state. For example, a spouse can't just decide to become a Florida resident because their service member is a resident there. But under federal law, they can borrow their service member's legal residence for tax purposes.

Second, the protections under SCRA, allowing the service member to attribute income to a state different from the state where it is earned, still apply only to the service member's military earnings. While the SCRA protects all spouse earnings, any non-military income of the service member is not protected and must be attributed to the state where it is physically earned. In addition, non-earned income may be subject to state taxation where it is earned. This might include rental real estate or other types of income.

So if both a service member and spouse do DoorDash on the weekends, that income can be attributed to the state of legal residence if earned in the spouse's name but will be taxed where earned if it is in the service member's name.

What's the Summary

Under current federal law, active-duty service members and their spouses may have the option to elect to use either their state of legal residence or permanent duty station for purposes of state taxes. Additionally, military spouses may retain their properly obtained state of legal residence when they move on their service member's PCS orders, regardless of what state law says.

Picking and choosing between states for state taxes may present some state tax savings for active-duty family members. However, keep in mind that there may be second- and third-order effects to the choice of where to file taxes. Think things through before making your choice, and be sure some loophole doesn't make your situation different.

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