If you are a Service Member serving in a combat zone (any area the President of the United States designates by Executive Order as an area in which the U.S. Armed Forces are engaging or have engaged in combat), you are able to exclude portions of your income from federal and state taxation. This does not mean the Service Member will not owe any taxes. While the federal government excludes all military pay from being taxed, some states allow only partial exclusion or none at all. If you serve in a combat zone for one or more days during a particular month, you are entitled to an exclusion for that entire month.
If you are an enlisted member, warrant officer, or commissioned warrant officer and you serve in a combat zone during any part of a month, all of your military pay for that month is excluded from your taxable income.
If you are a commissioned officer (other than a commissioned warrant officer), exemption is limited to an amount equal to the base pay of the Sergeant Major of the Army plus Hostile Fire/Imminent Danger Pay. For 2006, this amount was $6,724.50 per month. For 2007, this amount is 6867.60 per month. Income earned above this amount is fully taxable.
Military pay earned while hospitalized as a result of wounds, disease, or injury incurred in the combat zone are also excluded from taxable income. The exclusion of military pay while hospitalized does not apply to any month that begins more than 2 years after the end of combat activities in that combat zone. Hospitalization does not have to be in the combat zone.