You do not have to report your nontaxable pay as a member of the Armed Forces. Examples of nontaxable military pay are combat pay, the Basic Allowance for Housing (BAH), and the Basic Allowance for Subsistence (BAS). Your nontaxable combat pay is listed on Form W-2, box 12, with code Q.
But you and your spouse can each choose to count your nontaxable combat pay as earned income to qualify for the Earned Income Tax Credit. Doing so still doesn't make combat pay taxable though. Including it as earned income may decrease the amount of tax you owe and may mean a larger refund. When you do your taxes with 1040.com, it’s easy to try both ways — with combat pay included in earned income and without — to find out which is best for you.
If you make the election, you must include in earned income all nontaxable combat pay you received. You can't choose to include only part of it. But, each spouse gets to choose, so here are the option combinations:
One of the EITC requirements is that you lived within the U.S. at least half of the year. But service members on extended active duty outside the U.S. are considered to live in the U.S., so they meet the credit's residence requirement.
Taxes for U.S. Service Members
Financial Challenges for Military Families