I have a question pertaining to how taxes are calculated with concern to military separation pay (not severance pay). I will use round numbers for ease of use in understanding what I am trying to say here.

Say a military member was separated from the military in 2014. At the time of the separation, the member was given a lump-sum payment (separation pay) of $70,000 and this amount was taxed at the standard 28% rate. Within the same year, this same member received his VA award letter giving him a disability rating. The Award letter states that the $70,000 given in separation pay will off-set future award of payments, and the member does not receive any payment on that rating until the original amount is paid back. Now, here is the question.

Should the original $70,000 be viewed as income by the tax preparer? Disability payments are not viewed as income on any given year, and due to the VA using the separation payment as an advance payment, despite the two being paid out for separate instances (one being a pay for separating from the service, and the other being non-taxable disability payments)? Can the filer submit a 1040X with the VA letter to bring down the taxable wage for the year to read income from previous year, minus the lump-sum separation pay? Any help will be greatly appreciated. The way I see it, I was given an amount for leaving the service, only to have compensation from disabilities I incurred in the military with logic following the concept that the separation pay was an advance on disability compensation, even though the two are not connected. I think I should be able to count the original $70k as non-taxable income, and I should be able to subtract that amount from my taxable wages for the year in which I received payment.