Hello and thank you for using Just Answer,
You have a point of logic in your thinking but here is how you would deal with the fact that you were already taxed on the lump sum.
If your disability rating was retroactive to the date of your discharge, you can go back and amend your return for the year of the payment. You will show the lump sum payment as a negative under Other Income , this will remove the amount from your income for that year and you should receive a full refund on any amount you did not get because of the lump sum being added to your income for that year.
You will have to send in a copy of your disability determination letter and a statement showing the calculation used to get the nontaxable portion. The statement is very important especially if the VA did not give you 100% disability. You should still do the calculation even if you are 100% under VA. You will need to refer in your 1040X to St Clair determination as to why you are amending.
Make sure you only send copies of your determination letter with the 1040X and highlight the portion that shows the retroactive date.
If you are not comfortable dealing with the amended return, get a tax professional to do it for you as long as they say yes they know about St Clair and retroactive disability.
Arizona will also need to be amended.
Now if all this just happened and your payment was made to you in 2012 then the military will issue you a W2 showing the full amount along with the withholding. You will then report that as income on your 2012 return and then on line 21 do all the other I stated to subtract the amount out of your income and receive your withholding amount back as a refund.
I had to add this because when re reading your post I could not be sure if you meant 2011 or 2012 for the payment..