Alaska, Hawaii, US Territories…Higher Pensions Later, Higher Taxes Now

Federal Employees in non-foreign areas, like Alaska, Hawaii and Puerto Rico, are being transitioned from receiving COLA to Locality Pay.  The move to Locality Pay started in 2010, and will be complete in 2012.

Key Points You Should Know

  • Affects current Federal Employees in Non-Foreign Areas like Alaska, Hawaii & Puerto Rico…however most Postal Employees are not included in transition.
  • Locality Pay phased in over 3 years: 2010, 2011 and 2012
  • COLA is phased out, but some ‘left over’ COLA will remain
  • Locality Pay means higher taxes, this impacts your take-home pay now
  • COLA does not count towards High-3 Salary; Locality Pay does, this means higher pensions in retirement
  • Special rules to increase pension even more by ‘buying back’ COLA as Locality Pay for federal retirement

The way the transition works, in 2010 you received ⅓ of the RUS (Rest of US) Locality Rate, which was 14.16%.  In 2011, you receive ⅔ of your region’s new Locality rate.  In 2012, you receive your region’s full Locality Pay rate. You’ll still get a portion of COLA, but it goes down as Locality pay goes up.

Each region has its own COLA and Locality Pay rates.  Here is an example of how the calculations work for Anchorage, Fairbanks and Juneau, Alaska…

 In 2011, the Alaska Locality Pay rate was set at 24.69%.  The Non-Foreign Area Retirement Equity Assurance Act outlines that you get ⅔ of that rate in 2011.  So Federal Employees in Anchorage, Fairbanks and Juneau receive 16.46% Locality Pay.  The formula for ‘left over’ COLA comes out to 10.56% in 2011.  In the example, you can also see the estimates for 2012, based on 2011 rates.

“What Does This Mean to Me?”

I teach CSRS and FERS pre-retirement classes in Anchorage Alaska.  We talk about the COLA Locality Pay transition in class because people still have lots of questions about it.  They want to know how it works and how it affects their federal retirement.  

Here are some of the highlights:

Higher Pensions Later…

Going from COLA to Locality Pay means higher pensions in retirement.  COLA is not counted in your High 3 Salary for federal retirement.  But Locality Pay is.  The more Locality Pay you get, the higher your High 3, the bigger your federal retirement pension.  

But remember that you’re only getting ⅓ of the RUS Locality Rate in 2010, and ⅔ of your region’s locality pay in 2011.  

If you’re thinking about retiring in the next few years, you should know about a special provision in the Non-Foreign AREA Act.  It allows you to ‘buy back’ the full amount of Locality Pay you would have gotten if it weren’t being phased in.  But only if you file the proper election and retire on or before 12/31/2012.  This could help increase your CSRS or FERS pension even more.

There are other rules and limits involved.  To learn more and see examples of how much it costs and how it affects your pension, visit my page on ‘buying back’ COLA for retirement.

Higher Taxes Now…

So a higher pension in retirement is the good news.  The bad news?  You’ll be paying higher taxes now.  

In the legislation, it states “It is the sense of Congress that — the application of this subtitle to any employee should not result in a decrease in the take home pay of that employee.”

But notice it says, “should not”… that’s very different from “will not”.

In the transition, a portion of COLA is ‘left over’ to help pay for the increased taxes you’ll owe with Locality Pay.  But this will not be enough for everyone.  

When this legislation first came out, I ran tax projections for my federal employee clients.  In every scenario I ran, their taxes went up and their take home pay went down.  

For some people, the higher taxes meant their take home pay only went down by a small amount, maybe down by a couple hundred dollars a year.  
But others will be hit with ‘hidden’ tax increases.  I call them hidden, because most federal employees won’t see them until it’s too late.

Examples of ‘Hidden’ Tax Increases

Here are three big ‘hidden’ tax increases that could affect you:

   1. Phase-Outs: Locality Pay means your taxable income goes up.  As it goes up, you may no longer be allowed to take deductions you used to be able to take on your taxes. For example, if Locality Pay bumps you over $125,000 (married filing joint) – you can’t take certain real estate deductions. Once you hit $179,000 (married filing joint), you can no longer contribute to a Roth IRA.

   2. Next Tax Bracket:  Going from COLA to Locality pay, your taxable income is higher.  A higher income could bump you into the next higher tax bracket. This means that every additional dollar you earn is being taxed at a higher rate.

   3. Health Care Taxes: Some federal employees will be surprised to find that they are now subject to new Health Care taxes. I see this issue come up particularly when you have two married federal employees.  Say you and your spouse both earned $100,000. While you received ($23,000 + $23,000 =) $46,000 in COLA before it wasn’t counted towards your taxable income. Now with Locality Pay (at approx 25% for Alaska) – your taxable income is no longer $200,000 – but $250,000…. which means you’re now subject to extra taxes associated with the new Health Care rules.

Is COLA to Locality Good or Bad for Federal Employees?

The best benefit is for federal employees who are retiring in the next few years.  During your career in a Non-Foreign Area, you received tax-free COLA.  But now at the end of your service, you’ll get Locality Pay which will help increase your federal retirement pension.

The downside is the higher taxes.  But now that you know that Locality Pay will affect your taxable income – you can plan accordingly.

When you know your taxable income will be going up, there are steps you can take to reduce your tax bill.  They key is that you have to prepare for it.  Tax planning is just one of the ways I help my Federal Employee clients. I talk with my clients, and we ask, “What can we do to lower your tax bill now, and in the future?”

However, the worst thing about this change, in my opinion, is the lack of understanding of how it affects you now.

Most people have heard that Locality Pay will increase their federal retirement, but they don’t know that this will affect their taxes and take home pay now.  Please help spread the word.  Federal Employees in Alaska, Hawaii, Puerto Rico  and the other territories need to understand how this change will affect them now and in retirement.

To learn more about how the COLA to Locality Pay Transition works, and to see examples of the current COLA and Locality Rates for Alaska, Hawaii, Puerto Rico, Guam & other US Territories, visit my page on COLA Locality Pay.

© 2016 Micah Shilanski, CFP®. All rights reserved. This article may not be reproduced without express written consent from Micah Shilanski, CFP®.

About the Author

Micah Shilanski is a Certified Financial Planner™ professional who specializes in helping federal employees get the most out of their retirement benefits. Micah helps his clients with tax planning, retirement planning, federal retirement planning, estate planning, and investment advice.

Plan Your Federal Retirement is a dba of Shilanski & Associates, Inc., an Alaska Registered Investment Advisor, with securities offered through Summit Brokerage Services, Inc., Member FINRA/SIPC.