The portion of your pay received as a result of your disability rating is non-taxable; however, the portion received based on your years of service is taxable.
Military retirement pay and VA disability compensation are completely separate forms of compensation with different tax treatment. They are paid from different agencies and represent two different forms of compensation. Military retirement pay is a pension that is based on your years of service. VA disability compensation is a monetary award that is based on your decreased ability to perform work after leaving the military.
Your disability pay comes from the VA, and is not included on the 1099-R you received from DFAS for your military pension. No adjustment is necessary for tax purposes.
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