The 2025-26 Budget: Partial Income Tax Exclusion for Military Retirement Income

Background

State Income Tax. The personal income tax (PIT) is a broad-based tax that the state levies on most types of income, such as wages, capital gains, and some retirement income. The state’s income tax ranges from 1 percent to 12.3 percent. The PIT is an important revenue source for the state, generating over two-thirds of General Fund revenue.

Military Retirement. The United States Armed Services offer retirement pension benefits to servicemembers who complete 20 years of service. In retirement, eligible members receive 2 percent to 3 percent of the member’s highest salary for each year of service they completed. (Recent federal military retirement reforms reduced the yearly service credit from 3 percent to 2 percent.) For example, a veteran who retires after 25 years would receive annual retirement income equal to 50 percent to 75 percent of their highest salary. About half of officers serve long enough to receive this retirement benefit and about 20 percent of non-officers serve long enough. Servicemembers who leave service prior to the 20-year requirement do not receive pension benefits but may have individual retirement accounts from their time in the armed services. Military retirement benefits may be transferred to a surviving family member in the form of a military survivor partial benefit.

Veterans in California. About 1.4 million veterans live in California. The vast majority of California veterans do not receive military retirement benefit payments because relatively few members serve 20 years. According to Department of Defense payment data, about 140,000 military retirees in the state receive monthly military retirement income. This equates to about 10 percent of all veterans living in the state.

California Taxes Military Retirement Income. California does not tax Social Security retirement income but does tax other forms of retirement income, including military retirement income. As an illustration, a married-filing-jointly taxpayer with $75,000 in military retirement income (and no other income) would be in the 4 percent tax bracket and owe about $1,800 in state income tax.

Other States Fully or Partially Exempt Military Retirement Income. California is the only state that does not fully or partially exempt military retirement income from state taxation. Currently, nine states have no state income tax, 25 states fully exempt military retirement income, and the rest partially exempt military retirement income from taxation. Military retirement income is subject to the federal income tax.

Proposal

Excludes $20,000 in Military Retirement Income for Most Veterans. The 2025-26 Governor’s Budget proposes to exclude from state income taxation up to $20,000 in annual military retirement benefits. The exclusion would be available to individual taxpayers with less than $125,000 in adjusted gross income (AGI) or joint taxpayers with less than $250,000 in AGI. The exclusion would also apply to partial military survivor benefit income.

Stated Goals: Tax Relief and Making State More Competitive. The administration has put forward this tax exclusion for the stated purpose to (1) provide tax relief for California families with members who served in the military and (2) improve the state’s competitiveness in attracting and retaining military retirees to the state.

Proposed Income Exclusion Would Reduce State Revenue by $85 Million Annually. The administration estimates that the proposed income tax inclusion would result in roughly $85 million in foregone revenue annually.

Analysis

Provides Some Tax Relief. The partial income tax exclusion of military retirement income would reduce state taxes for 130,000 veterans in the state. The maximum benefit available under the proposal equates to a $600 tax reduction for the average military retiree. The tax savings would be larger for military retirees with higher incomes, most commonly working veterans with nonmilitary wages. Conversely, the tax savings would be smaller for military retirees with minimal tax liabilities.

Moves California More In-Line With Other States. Under the proposal, California would no longer be the only state to fully tax military retirement benefits. Due to the relatively modest exclusion ($20,000) and income limitations, California’s tax treatment of military retirement benefits would nevertheless remain among the country’s most limited. 

Compared to Balance of Factors That Influence Location Decisions, Proposal’s Financial Incentive Is Minor. Taxpayers make decisions about where to live and work based on a complex balance of factors that includes job prospects, community preferences, cost of living, climate, quality of government services, and local tax levels. Relative to these broader factors, the proposal’s financial incentive is minor. Therefore, the income tax exclusion is not likely to change many veterans’ decisions about where to live after their service. As such, the proposal likely achieves little on the administration’s stated goal of making the state a more competitive destination for military veterans. That said, under the proposed change, the state would no longer be the only state that fully taxes military retirement income. In this sense, although it is a small financial incentive, the proposal may well improve veterans’ perception of California.

Weak Economic Rationale to Exclude Military Retirement Income From Taxation. Providing tax relief to military veterans with retirement income who already live in the state is not likely to provide compelling economic benefits to the state. Tax expenditures are often put forth to encourage certain behaviors or spur economic activity that benefits the state or other groups. Yet neither outcome is likely to occur to a noticeable extent under this proposal. As such, the proposal does not have a strong economic rationale when compared to alternative uses of these funds, either for a different tax expenditure or other state spending. For their part, these alternatives could have positive benefits that should be weighed against the potential benefits of the proposal.

Tax Expenditures Should Clear High Bar. Relative to spending proposals, tax expenditures tend to be reviewed less rigorously once they are adopted. Furthermore, again relative to spending proposals, assessing the effectiveness of tax expenditures is challenging given the limited information the state receives about taxpayers who benefit. As such, proposed tax expenditures should clear a very high bar for adoption.

Considerations

Path Forward Depends on What Legislature Hopes to Achieve. Our assessment is that the economic and fiscal rationale for this proposal is weak. Nonetheless, we recognize that other factors often are relevant to the Legislature’s decisions. In assessing the administration’s proposal, the Legislature will need to decide if these other factors are enough to support this tax change. If the Legislature simply wants to provide limited tax relief to veterans, that might also improve veterans’ perceptions of the state, it could adopt the administration’s proposal. If the Legislature instead prefers that this tax expenditure have a clear economic or fiscal rationale, it could reject the administration’s proposal.