COLA to Locality Pay

Take Home Pay Concerns & Hidden Tax Increases

The transition from COLA to Locality Pay for Federal Employees in Alaska, Hawaii and U.S. Territories brings concerns about take home pay and higher taxes.

While the transition was designed to 'protect take home pay'... many Federal Employees will see their take home pay going down.

Why? Higher taxes...

COLA was tax-free. Locality Pay is taxable. Going from COLA to Locality Pay means your taxable income is higher.

Not only will you be paying more taxes - but you're likely to get hit by what I call 'hidden' tax increases. I call them hidden, because most Federal Employees won't see them until it's too late.

The Sense of Congress and Your Take Home Pay

In the legislation, it says...

"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."

Why are they talking about take home pay? Because COLA is tax-free, and Locality Pay is taxable. Moving from COLA to Locality Pay means more taxes for you.

The formula for the transition was designed to leave some 'left over' COLA to offset the higher taxes that you'll be paying on the Locality Pay.

And to be fair, I think that Congress did do a decent job of trying to structure the transition in a way that would have less impact on your take home pay.

But notice the words ... "should not"... in the legislation.

In my experience, they choose words very carefully when it comes to legislation... and "should not" is very different from "will not".

Some Examples Show Higher Pay, But Forget Higher Taxes

Many of the examples you might see about this transition often show your pay going up as a result of the transition.

What is often left out is your tax bill. Going from COLA to Locality Pay increases your taxable income - and therefore increases your tax bill. But you rarely, if ever (?) see that mentioned in the examples.

It's important to understand that while your pay may be going up - so will your taxes.

When I Ran Some Tax Projections...

When the COLA to Locality legislation first came out, I ran several scenarios for my federal employee clients. We looked at how their take-home pay, after taxes, would be affected.

In every scenario that I ran, their take home pay went down. The good news was that it wasn't down by a huge amount, but it was still down in every scenario.

I contacted one of the Senators for Alaska (where I live & work). I sent them my scenarios and asked if I was perhaps missing something (hoping that I was wrong).

The response I got was very interesting, and I want to share it with you because it's important...

"...it is the intent of Congress for employees’ pay not to go down. The legislation is crafted to do that as much as possible and OPM is on board with working to ensure that doesn’t happen. The way the offset was crafted, it should protect employees’ take home pay by leaving a portion of COLA to help ease the burden from the higher tax and retirement contributions. However, the legislation does not take into account each individual employee’s tax situation. "

The good news is, that the decrease in take home pay is probably pretty small at first glance.

However, that's not the end of the story when it comes to how this change affects your tax bill.

"Hidden" Tax Increases

This legislation affects your tax bill. How strong or how subtle the effect is depends on your personal situation. Tax planning is just one of the things I do for my clients.

Remember that the transition from COLA to Locality Pay will increase your taxable income. Even though the transition leaves you with some 'left over' COLA to offset (some) the higher taxes you'll owe - it won't be enough for everyone.

Here are some of the Hidden Tax Increases that many Federal Employee miss...

Examples of 'Hidden' Tax Increases

There are three big 'hidden' tax increases that could affect you:

  1. Phase-Outs: With a higher income, 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 (for married couples) - you can't take certain real estate deductions. Over $183,000 (again for married), and you can no longer contribute to a Roth IRA.

  2. Next Tax Bracket: Going from COLA to Locality Pay could bump you into the next higher tax bracket. This means that every additional dollar you earned is being taxed at a higher rate.

  3. Health Care Taxes: Locality pay can increase your taxable income enough to make you subject to the new Health Care Taxes. This is especially an issue for 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.

What Can You Do to Lower Your Tax Bill?

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?"

Tax planning is complex. And if you mess up at tax planning, the consequences are serious and expensive. It’s worth having assistance from someone who does this for a living.

However, many professionals are really more focused on tax-preparation: what happened, what form does it go on, and 'poof'—here's how much you owe...now cough it up.

***The key to good tax planning is a future-orientation. You want to be asking the question, "What can I do to lower my taxes in the future?"***

Good tax planning helps you use the tax laws to your best advantage. It can also help keep more of your money in your pocket. You are legally required to pay taxes, but you are legally entitled to organize your finances in a way to pay the least amount of taxes required.

Find out more about how taxes affect your federal retirement.

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