If you retire from the armed services based on years of service and are later given a retroactive service-connected disability rating by the VA, your retirement pay for the retroactive period is excluded from income up to the amount of VA disability benefits you would have been entitled to receive. You can claim a refund of any tax paid on the excludable amount (subject to the statute of limitations) by filing an amended return on Form 1040X for each previous year during the retroactive period.
Generally, under the statute of limitations a claim for credit or refund must be filed within 3 years from the time a return was filed or 2 years from the time the tax was paid, whichever period expires later. However, if you receive a retroactive service-connected disability rating determination, the statute of limitations is extended for 1 year beginning on the date of the determination. The extension applies to claims for credit or refund filed after June 17, 2008, and does not apply to any tax year that began more than 5 years before the date of the determination
Example.You retired in 2004 and receive a pension based on your years of service. On August 6, 2009, you receive a determination of service-connected disability retroactive to 2004. Generally, you could claim a refund for the taxes paid on your pension for 2006, 2007, and 2008. However, under the special limitation period, you can also file a claim for 2005 as long as you file the claim by August 5, 2010. You cannot file a claim for 2004 because that tax year began on January 1, 2004, which is more than 5 years before date of the determination.