Pastor tax deductions

How the IRS sees a pastor

The IRS, the federal tax agency, treats a pastor on the church payroll as an employee for income tax. Social Security and Medicare work differently. These are the federal taxes that pay for retirement benefits and for health insurance after 65. For these two, you're treated as if you work for yourself, even though the church employs you.

So you pay them yourself, as one tax called self-employment tax. For other staff, the church pays half of these taxes. For you, it doesn't. That's why you pay no income tax on your housing allowance, but you still pay self-employment tax on it.

What can you still deduct?

A deduction is an amount taken off your income before your tax is figured out, so you pay less. Since 2018, ministry costs you pay yourself, such as books or travel, no longer lower your income tax. These still help:

• Your housing allowance, or the use of a church-owned home (a parsonage). You pay no income tax on either one.
• The interest on your home loan (your mortgage) and your property taxes, the yearly tax on your home. These still count even if you paid them with tax-free housing money. They only help if you itemize, which means listing your deductions one by one. Most people take the standard deduction instead, a set amount anyone can take.
• Half of your self-employment tax. You take it off your income on your tax return, so your income tax goes down.
• Costs for weddings, baptisms and speaking jobs you take on your own. These go on Schedule C, the form for income from your own work.
• Work costs the church pays back through an accountable plan.

An accountable plan is a way of paying back work costs that follows IRS rules. When the church uses one, the money it pays back isn't added to your Form W-2, the form that shows your pay for the year.

If you pay a work cost yourself and nobody pays you back, it still helps a little. It lowers the amount your self-employment tax is based on.

One catch: because part of your pay is tax-free housing money, you may only be able to deduct part of your Schedule C costs, the costs from your own weddings, baptisms and speaking jobs. A tax preparer can tell you how much.

How much of the housing allowance stays tax-free?

The housing allowance is the part of your pay the church sets aside for your home. For a home you own or rent, only the smallest of these three amounts is free of income tax:

• the amount the church set
• what you actually spent on your home
• what your home would rent for, furnished, plus bills such as electricity and water (utilities)

The last one is called fair rental value. It means what a similar furnished home nearby would rent for between people who aren't related.

This means a bigger allowance doesn't always give you more tax-free money. You also need to spend it on your home, and your home needs to be worth that much in rent.

You don't have to compare the three amounts yourself. The housing allowance calculator does it for you.

The allowance has to be used in the year it is paid. Any part that isn't tax-free goes on your yearly tax return, Form 1040. It goes on the line marked "Excess allowance", which simply means the extra part that is taxed.

If you live in a parsonage, you pay no income tax on its full rental value. If the church also gives you money for utilities, that money is tax-free only up to what you spend on them. Whatever kind of home you have, the tax-free amount can't be more than a reasonable salary for your work.

Setting up the housing allowance ahead of time

The church has to approve the allowance before paying it and write down the exact amount. This can go in your contract, the church minutes (the written notes of a board meeting), the budget or another official decision.

A friendly chat with the board isn't enough. If nothing was written down before the money was paid, the IRS won't let that money be tax-free.

Self-employment tax on your ministry earnings

Self-employment tax is the Social Security and Medicare tax you pay for yourself. It is charged on most of your ministry pay, after work costs. It also covers your housing allowance or the rental value of your parsonage, even though you pay no income tax on them.

The self-employment tax calculator estimates what you owe. Two things are good to know:

• Money you put into a 403(b), a retirement savings plan for church and nonprofit workers, isn't counted, even when it comes out of your own pay.
• If you earn less than $400 from this work after costs, you owe no self-employment tax at all.

Can a pastor opt out of paying self-employment tax?

Yes, but only for reasons of faith or conscience. Opting out means asking the IRS not to charge you this tax on your ministry earnings. You ask on Form 4361, the IRS application for this, if you object to the tax for religious reasons or deeply held moral beliefs. Wanting to save money isn't a reason the IRS accepts.

You need to apply early. The deadline is the due date of your tax return for the second year in which you earn $400 or more from ministry and other work for yourself. A tax preparer can tell you the exact date. Once approved, the choice is permanent, so it's worth talking it over with someone you trust first.

Paying tax through the year

If the church doesn't take income tax out of your pay, you may need to send money to the IRS four times a year. These are called estimated tax payments. Paying this way helps you avoid a penalty, which is an extra charge for paying late. You send them with Form 1040-ES, which comes with a payment slip for each one.

You can also ask the church to take tax out of each paycheck. This is called voluntary withholding, because withholding means taking tax out of pay before you get it. The church can take out enough to cover both your income tax and your self-employment tax.