Which type of separation pay is not subject to Federal Income Tax Withholding (FITW) or State Income Tax Withholding (SITW)?

Disability severance pay is the type of separation pay that is not subject to Federal Income Tax Withholding (FITW) or State Income Tax Withholding (SITW). This classification is based on the nature of the payment, which is intended to provide support to service members who are medically unfit for service due to a disabling injury or condition.

The rationale behind this exemption is to acknowledge the unique and often challenging circumstances surrounding disability, which may necessitate additional financial support during recovery or transition. By not taxing this form of pay, it allows veterans to retain more of their benefits to manage their health and well-being without the burden of immediate tax liability.

In contrast, other forms of separation pay, such as regular separation pay, voluntary separation pay, and retirement pay, do generally face withholding requirements because they are considered compensatory in nature for services rendered or a change in employment status.