Military Pension Inflation Protection – How and Inflation Indexed Pension Keeps Up with Cost of Living

Let’s consider some of the details behind a military pension and its COLA.

First, just like active duty pay or drill pay, the pension is paid in arrears. In this case it doesn’t show up until the first of the month and it’s only paid once a month. The first payment may even be delayed a week or two if the computer network at the Defense Finance and Accounting System had a delay or an error in processing that month’s new retirement data. In case of a rare delay, new retirees should have enough cash on hand for the first two months of retirement. The system will eventually catch up.

Next, except for extremely unusual circumstances requiring individual DFAS processing, the pension will be paid by electronic direct deposit to the account of your choice. (The federal government does not want to mail paper checks.) If it’s the same account you’ve always used for your pay then there’s no change and no problem. If you’re planning to use a different bank or credit union because you’re moving to a new area then you might consider delaying that shift until you’re moved in and settled. DFAS’ pension-processing system requires a week or two to change to the new financial institution, and you don’t want to compound a relocation with bank problems.

Finally, keep an eye on your service’s electronic pay system for the first few months of retirement. New (or corrected) pay statements may be posted as your service closes your pay accounts and formally transfers your records to the Department of Defense. In addition to your last pay statements, make sure any new pension deductions and allotments are correct and promptly notify DFAS of any problems.

Retirees are not required to have federal (or state) income tax deducted from their pension, and you can adjust your withholding as necessary. The more complicated you make your pension distribution, though, the more chances for problems. It may be easier to have the entire pension payment deposited to your financial institution and then set up your automatic deductions from that account. It’s probably a lot easier to reach your local credit union on the phone or by e-mail, too.

In December or January after your retirement, DFAS will distribute tax forms. These can be mailed if requested but usually default to online display on your service’s pay website. The W-2 should reflect your active-duty or drill pay as well as any leave (base pay) that was sold back during retirement. If the W-2 doesn’t appear to have the right amount then contact DFAS or your local pay office to check the calculation. If there was a processing error (especially with retirement leave) then DFAS’ computer systems will eventually catch up– and issue a corrected W-2. Murphy’s Law means that will happen the week after you file your tax returns.

Estimated taxes are another issue for your retirement year. You not only refer to your W-2 but also to your 1099-R pension distribution statement. Military retirement pay is subject to federal tax and is still taxed in some states. If you sold back leave as part of your retirement then that (base pay) is also subject to tax and estimated taxes may not have been withheld. Check your estimated taxes using the IRS worksheet and make sure that enough estimated tax is withheld (or paid by you) by the January deadline. Late tax payments are not only fined– you also pay interest on the balance.

After the first year, your pension payments and withholding should settle down to a routine. You’ll download your 1099-R each year and perhaps adjust your tax withholding as necessary. Ideally, it’ll be dull and boring and you’ll have trouble remembering your login and password.

Military retirees have two other issues to consider in their pension COLAs.

In January of the first full year of retirement, High Three retirees will not receive the full COLA. The High-Three pension system pro-rates the official COLA to a smaller amount for your pension depending on the month of your retirement. This reduced COLA only occurs during the first full year of retirement and the full COLA will be received in subsequent years.

If you’re one of the very few retirees who chose REDUX then you have a different challenge. Not only will your first full year’s COLA be pro-rated, but all of your pension COLAs will be reduced by 1% below the CPI until you turn age 62. A special “catch-up” adjustment is applied to the REDUX pension at that age, but you have to have faith that no legislative changes will occur to the system before then. After age 62, though, the COLA returns to its cap of 1% less than the CPI. If you retire at age 37 on 40% of your base pay (instead of High Three’s 50%) and give back 1% of your COLA for the next 25 years, then by age 62 your pension will only have 62% of the purchasing power of its High-Three equivalent. Your REDUX pension will receive its projected catch-up adjustment but will then resume losing ground on its inflation protection for the rest of your life.

The next post will go into greater detail on REDUX pensions and show a graphical comparison between REDUX and High Three pensions.

Related articles:
COLA calculations
Living with inflation
Effect of inflation on a dollar
Will Congress change military retirement?

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About Doug Nordman

Author of "The Military Guide to Financial Independence and Retirement" and co-author of "Raising Your Money-Savvy Family For Next Generation Financial Independence."
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