Understanding Housing Allowance and How It Affects Your Retirement Savings

For a lot of pastors, the housing allowance is an important part of their pay that comes with a lot of tax breaks. But it's also a complicated subject with unique IRS laws and consequences, especially when it comes to saving for retirement and preparing for the long term. If you don't understand or use the housing allowance correctly, you could lose tax savings and hurt your retirement security. This in-depth guide will help you understand everything about the housing allowance and how it affects your retirement funds, from the legal requirements and paperwork to tax planning and smart retirement planning. We'll also talk about some frequent mistakes that pastors make and how to avoid them.

What is the allowance for housing?

Also known as the parsonage allowance or clergy housing exclusion, the housing allowance lets pastors not pay federal income tax on part of their salary that is set aside for housing costs. Only clergy and some religious workers who are recognized by the IRS can get this benefit. The allowance applies to money that is paid as salary or other income that is specifically set aside for housing costs. It can cover things like rent, mortgage payments, electricity, property taxes, upkeep, and furniture. This tax break can lower taxable income by a lot, which means more money in your pocket and more money available for savings and investments.

The law and the IRS rules

Legal Power

Section 107 of the Internal Revenue Code (IRC) allows for the dwelling allowance. It doesn't count the rent value of a home given to a minister or the rent allowance they get. The religion or group that hires you must "officially designate" the allowance ahead of time.

Important IRS Rules

• Official Name: The housing allowance must be set in writing before the payment period starts. Usually, the church board or governing body does this.
• Reasonableness: The sum set aside can't be more than the real costs of housing or the reasonable rental value of the home, which includes utilities and furniture.
• Use of Funds: The pastor must use the allowance to pay for housing costs, but they don't have to show proof of spending it; they just have to show that it doesn't go beyond a reasonable amount.
• Reporting: The housing allowance is not taxed by the federal government, but it is taxed by self-employment tax unless the IRS says it is exempt under the ministerial exception.

What kinds of housing costs count?

Most of the time, qualified expenses are:

• Payments for rent or a mortgage (both principal and interest)
• Electricity, water, gas, and internet are all utilities.
• Taxes on property and insurance
• Fixes, upkeep, and upgrades
• Furniture and appliances
• Fees for homeowners associations
• Other fees that come up when you own a home

How to Properly Set the Housing Allowance

1. Approval from the board: At a meeting, church governing bodies must officially set the housing allowance and write it down in the minutes. Most of the time, this is done once a year or before each pay period.
2. Written Records: The designation should be in writing and include:
• The amount or formula used to figure up the allowance
• The time frame that is covered
• A declaration of purpose (costs of housing)
3. Talk to Payroll: Make sure that payroll handles the allowance correctly and that it shows up in your salary.

Tax Reporting and Housing Allowance Form W-2

For tax purposes, the housing allowance should not be included in Box 1 (wages) but should be reported in Box 14 or Box 12 with the code "L." But it is still counted in Boxes 3 and 5 for Social Security and Medicare unless the pastor is exempt.

Tax for Self-Employment

The IRS sees housing allowance as self-employment income that is liable to self-employment tax unless the pastor has filed Form 4361 to get out of paying it. The self-employment tax is about 15.3% and pays for Social Security and Medicare.

Things to Avoid When Getting a Housing Allowance

• Not officially writing down the allowance before paying it.
• Setting an amount that is more than appropriate housing costs or fair rental value.
• Including expenses that don't qualify, such as personal trips, in the allowance.
• Not accurately putting the allotment on the W-2.
• Not knowing what self-employment taxes mean.

The IRS can audit you, make you pay back taxes, and give you fines for these mistakes.

Effect on Savings for Retirement

More money left over after taxes. The housing allowance lowers taxable income, which means that pastors have more money left over to save and invest.

Getting the Most Out of Retirement Plan Contributions

Pastors can give more since they save money on taxes with the housing allowance:

• 401(k) and 403(b) plans for retirement
• IRAs and Roth IRAs
• Self-employed people can use SEP and SIMPLE IRAs for their income.

Maximizing contributions speeds your retirement growth by letting you grow your money tax-free or tax-deferred.

Planning for Taxes Can Be Hard

The housing allowance lowers your income tax, but it doesn't lower your self-employment tax, which pays for Social Security payments that are vital for retirement income. Understanding this small difference is very important for planning for retirement, especially for figuring out how much Social Security benefits you will get and how much you need to save for retirement.

Ways to Use Your Housing Allowance for Retirement

1. Make the most of retirement accounts that are tax-free: Use the money you save on taxes from the housing allowance to make bigger contributions to IRAs and employer-sponsored plans.
2. Think about savings and investments after taxes: If you hit your contribution limits, consider tax-efficient investment accounts to expand your savings.
3. Get ready for self-employment tax: Think about how the self-employment tax will affect your net retirement income and plan accordingly.
4. Hire Professionals: Work with financial professionals who know about tax difficulties for clergy to make complete retirement plans.

Housing Allowance and Planning Your Estate

The tax benefits of the housing allowance can have an effect on estate planning: More savings make it possible to set up trusts and endowments that will support the ministry's legacy. Good estate planning makes sure that your retirement assets are given out the way you want them to be, which lowers your taxes.

Recent Changes in IRS Law and Cases

The IRS and courts have made housing allowance regulations clearer and, at times, questioned them. To stay in compliance, you need to stay up to date.

How Church Law and Strategy Helps Pastors

Regan leads Church Law and Strategy, which gives skilled legal and financial advice on things like tax preparation, housing allowance designation, and retirement planning. Our membership programs, including THE FOUNDATION PLUS PLAN, give pastors ongoing help and instruction on how to follow the rules.

Summary Checklist:

• Learn about the housing allowance and how it affects your retirement savings.
• In writing, officially set the housing allowance each year.
• Keep thorough records of housing costs that qualify.
• Understand the effects of self-employment tax and tax reporting.
• Use tax savings to get the most out of your retirement plan contributions.
• Take into account your housing allowance income while planning for Social Security benefits.
• Don't make typical blunders while designating and reporting.
• Get help from financial and legal professionals who know how to work with clergy.
• Check the IRS guidelines and case law that are relevant to you on a regular basis.

In Conclusion

If you know how to use it correctly, the housing allowance is a great tax break that can really help pastors save for retirement. Pastors can protect their financial future and celebrate their lifelong ministry commitment by combining the right designation with smart retirement planning and competent assistance. Church Law and Strategy wants to assist pastors in getting the most out of these benefits while making sure they follow the rules, so you can develop a solid retirement foundation.

Links Inside

• Find out more about the legal strategy for pastoral recompense.
• Look at church legal audit and compliance reports.
• Learn about consulting for church tax strategies.

Links to Other Sites

• IRS Clergy Tax Guide: https://www.irs.gov/charities-non-profits/ministers-income-tax-guide
• ECFA Housing Allowance Resources: https://www.ecfa.org/Content/HousingAllowance
• Christianity Today Housing Allowance Overview: https://www.christianitytoday.com/ct/2019/june-web-only/irs-housing-allowance-pastor-ministry.html

This blog article is for informational purposes only and does not give legal advice. Reading this material does not make you a client of Church Law and Strategy or its representatives. Please talk to a professional lawyer for particular legal counsel that is right for your church or organization.