How Separation Pay Is Taxed
The gross vs net surprise
Separation pay is federally taxable at your ordinary rate. A $40,000 gross payment may net $28,000–$32,000 after federal and state taxes. The lump sum can push you into a higher bracket for that tax year.
The painful part: if you later receive VA disability, the VA recoups the gross (pre-tax) separation pay amount — not what you actually received after taxes. On $40,000 gross that netted $30,000, the VA still recoups $40,000 from your disability payments. You effectively pay taxes on money the VA takes back.
Planning: if you know you'll receive both separation pay and VA disability, consider increasing TSP contributions or making estimated tax payments to offset the taxable lump sum. Some tax advisors recommend filing an amended return to recoup taxes paid on the portion that was later recouped by VA, but this is complex and requires professional guidance.