Does NC Tax Military Retirement? Bailey Settlement and Deductions

North Carolina does not tax military retirement pay for qualifying retirees. A state law that took effect for tax year 2021 lets eligible service members deduct 100% of their military pension from North Carolina taxable income, which drops the effective state tax on that pay to zero.¹ The deduction covers recurring retirement pay and, in many cases, Survivor Benefit Plan payments. It does not cover military severance pay received at separation.

Who Qualifies

Two groups qualify under the 2021 law. The first is anyone who served at least 20 years in the Armed Forces of the United States. That includes the Army, Navy, Marine Corps, Air Force, Coast Guard, and Space Force. Reservists and National Guard members who reach the 20-year threshold for retirement pay qualify on the same terms as active-duty retirees.²

The second group is medical retirees. If you were retired under Chapter 61 of Title 10 of the U.S. Code because you were found unfit for duty due to a disability, your retirement pay qualifies regardless of years of service. Your retirement orders should cite Chapter 61 specifically. Disability severance pay is not covered.²³

The deduction applies to tax years beginning on or after January 1, 2021. If you retired before that date and were paying state tax on your pension, you should have been claiming the deduction on returns from 2021 onward.¹

The Older Bailey Settlement Path

Some retirees qualify under an older exemption from Bailey v. State of North Carolina, which barred the state from taxing certain government retirement benefits. To use Bailey, you must have had five or more years of creditable service as of August 12, 1989.⁴

Bailey is broader on one point: it does not require 20 years of service or a medical retirement. If you were vested by that August 1989 date, your full federal retirement benefit is exempt. Bailey also covers benefits from the Federal Employees’ Retirement System and U.S. Civil Service Retirement System, which matters if you moved into federal civilian work after your military career.⁴

If you fit both Bailey and the 2021 law, either one removes the state tax on your retirement pay. They go on different lines of Schedule S, so use whichever applies.⁵

Survivor Benefit Plan Payments

Payments from the military Survivor Benefit Plan are also exempt from North Carolina income tax, but only if the deceased retiree who purchased the coverage would have qualified. That means the retiree served at least 20 years, was medically retired under Chapter 61, or was vested by August 12, 1989, for Bailey purposes.¹

The beneficiary claims the deduction on their own North Carolina return. Because the deduction has been available since tax year 2021, survivors who have been paying state tax on SBP payments over that stretch should look at whether amended returns are worth filing. SBP annuity payments generally remain taxable at the federal level even though North Carolina exempts them.

VA Disability, CRSC, and CRDP

VA disability compensation is not taxed by North Carolina or the federal government, regardless of your disability rating or years of service. If VA disability is your only income, you likely owe no North Carolina income tax at all.

Combat-Related Special Compensation is a separate tax-free federal entitlement. Because CRSC isn’t included in federal adjusted gross income, it doesn’t reach your state return either.⁶

Concurrent Retirement and Disability Pay works differently. CRDP restores retired pay that was previously offset by VA disability compensation. The restored portion is taxable federally because it counts as retired pay, not disability pay. That restored retired pay qualifies for the North Carolina military retirement deduction if you meet the 20-year or medical retirement requirements.

What’s Still Taxable

Federal income tax still applies to military retired pay in most cases. DFAS withholds federal tax based on the W-4 you filed at retirement or updated later through myPay. If you claim exempt status, the IRS requires you to recertify each year with a new W-4. Skip the recertification and DFAS defaults your withholding to single with zero exemptions, which can lead to over-withholding until you correct it.⁷

Thrift Savings Plan withdrawals are a separate matter from your pension. North Carolina does not automatically exempt them. Traditional TSP distributions are taxable as ordinary income at both the federal and state level, and the TSP doesn’t withhold state taxes, so you may need to make estimated payments or adjust withholding elsewhere.⁸

Roth TSP contributions come out tax-free because you already paid tax on them. Roth earnings are tax-free only if the distribution is qualified: at least five years since January 1 of the year of your first Roth TSP contribution, and you are 59½, permanently disabled, or deceased. Otherwise, the earnings portion is taxable and may face a 10% early withdrawal penalty. That penalty does not apply to any portion of a TSP distribution representing tax-exempt contributions from combat zone pay, and qualified reservists called to active duty may also be exempt under Internal Revenue Code section 72(t)(2)(G).⁸⁹

How to Claim the Deduction

File Form D-400, the North Carolina Individual Income Tax Return, with the supplemental Schedule S. Schedule S is where you list subtractions from federal adjusted gross income, and which line you use depends on which exemption fits your situation.⁵

Line 20 is for the Bailey Settlement. Use it if you were vested with five or more years of creditable service as of August 12, 1989. Attach a copy of your Form 1099-R.
Line 21 is for the 2021 military retirement deduction. Use it if you qualify through 20 years of service or a Chapter 61 medical retirement. Keep your DD-214 or equivalent documentation available.

The amount you enter should match the retirement distribution shown on your Form 1099-R for the tax year. Survivor Benefit Plan beneficiaries follow the same process using the 1099-R issued for their SBP payments.⁵

For tax year 2025 returns, the filing deadline is April 15, 2026. Even if your entire retirement income is exempt under Bailey or the 2021 law, you still need to file a North Carolina return if your gross income meets the state’s minimum filing threshold.¹⁰

1
NCDOR. Important Notice: North Carolina Enacts New Deduction For Certain Military Retirement Pay and Survivor Benefit Plan Payments
2
NCDOR. Military Retirement
3
Office of the Law Revision Counsel. 10 USC Ch. 61 – Retirement or Separation for Physical Disability
4
NCDOR. Bailey Decision Concerning Federal, State and Local Retirement Benefits
5
NCDOR. North Carolina Individual Income Tax Instructions
6
Defense Finance and Accounting Service. Combat Related Special Compensation (CRSC)
7
Defense Finance and Accounting Service. Federal Income Tax Withholding
8
TSP.gov. Changes to Tax Rules about TSP Payments
9
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
10
NCDOR. The NCDOR Opens 2026 Individual Income Tax Filing Season