COLA Impact on Hawaii Federal Employees

If you have clients who are civilian employees of the U.S. Government in Hawaii and they receive a Federal cost-of-living allowance (COLA), they do not pay Federal income tax on their COLA.

The Internal Revenue Service reminds you, however, that COLA has an impact on the amount of Federal tax your clients pay if they itemize deductions.

Part of State income tax paid is not deductible
According to IRS Revenue Ruling 74-140, employees in Hawaii cannot deduct the portion of the Hawaii State income tax they pay that is allocable to a cost-of-living allowance exempt from Federal tax. This ruling affects only those taxpayers who itemize their deductions on their Federal tax returns.

Calculation to figure deductible portion of State income tax paid
You may use the following calculation to figure the amount of Hawaii State income tax to claim as an itemized deduction on your clients’ Federal tax returns:

1) COLA / Federal Adjusted Gross Income + COLA = Percentage Attributable to COLA

2) Percentage Attributable to COLA x Total State Income Tax Paid = Nondeductible Portion

3) Total State Income Tax Paid minus Nondeductible Portion = Deductible Portion

Example 1: In tax year 2006, your client paid $5,000 in Hawaii State income tax and received COLA of $10,500. Your client’s Federal adjusted gross income was $50,000.

1) $10,500 / $50,000 + $10,500 = 17%

2) 17% x $5,000 = $850 Nondeductible Portion

3) $5,000 - $850 = $4,150, Deductible Portion on the 2006 Federal Tax Return

Benefit the following year
This works to your clients’ advantage the following year if they receive a Hawaii State income tax refund. When reporting the refund as taxable income on their Federal tax return, your clients can reduce their State refund by the same percentage used to reduce their State tax deduction on their previous year's Federal tax return.

Calculation to figure amount of State refund to include as income
You may use the following calculation to figure the amount of your clients’ Hawaii State income tax refund to declare as taxable income on their Federal tax returns:

1) State Refund x Previous Year’s Percentage Attributable to COLA = Excludible Portion

2) State Refund minus Excludible Portion = Includible Portion

Example 2: Given the same facts as in Example 1, in 2007, your client receives a refund of $590 from the 2006 Hawaii State income tax return.

1) $590 x 17% = $100 Excludible Portion

2) $590 - $100 = $490, Includible Portion on the 2007 Federal Tax Return

Revenue Ruling
Revenue Ruling 74-140 has been in effect since 1974 (1974-1 C.B. 50).

No affect on Hawaii State tax returns
IRS Revenue Ruling 74-140 and the calculations described in this information release apply to Federal returns only. They do not affect Hawaii State tax returns.

Information contained herein provided by the Internal Revenue Service, SBSE Division