Going all the way back to the Truman administration, federal employees stationed in non-foreign areas of the United States have received cost-of-living allowances based on the difference in costs between where they were working and home base, Washington, DC. Because these "allowances" were non-taxable, they have never been considered to be a part of basic pay for retirement purposes.
That changed when the 2010 National Defense Authorization Act was signed on October 28, 2009. It provided that over a phased-in period, these cost-of-living allowances would be treated like locality pay. Thus, they would both be taxable and considered to be a part of basic pay for retirement purposes.
In 2010, for every dollar employees receive in locality pay, 65 cents will be removed from their non-foreign COLA. As a result, they’ll be receiving both locality pay and non-foreign COLA. That allowance will shrink each year as their locality pay increases until their post-tax pay is equal to or higher than what they would have gotten if the law hadn’t changed. Looks like good news for the approximately 41,000 federal employees working in Alaska, Hawaii, Guam and the Northern Mariana Islands, Puerto Rico, and the U.S. Virgin Islands.
To receive this credit in their annuities, employees who retire between January 3, 2010 and December 31, 2012, will have to pay a deposit to their employing agency. The amount of that deposit will be based only on the portion of the COLA that is being treated as basic pay.
Agencies will be responsible for determining the amount of the deposit and collecting it. Once the agency has the deposit, it will forward it to OPM, along with its appropriate contribution amount. Note: It’s easy to forget that employees aren’t the only ones who pay for future retirement benefits. Agencies have to pay their share, too.