The pastoral housing allowance can be a great tax deduction for pastors. But if you don’t prepare for the surprise swap up on your taxes, you may end up paying a housing allowance penalty.
I have seen church planters fall prey to this and wind up with a huge tax bill come April. To be fair, it’s not really a housing allowance penalty so much as an oops-wasn’t-prepared-for-that. You don’t have to learn this lesson the hard way as so many of us have.
A Scenario with Numbers
Joe Planter finds himself in the 15% income tax bracket. But he’s still in the social security system, so he pays another 7.65% on top of that, for an effective tax rate of 22.65% (deductions & write offs aside). He’s going to be paid a salary of $4,000/mo, so the church will withhold $600/mo in income tax (15%) and another $306/mo for social security (7.65%; technically ‘self employment tax’ for clergy) for a total $906.
But he requests (in advance, of course) that $1,500/mo be designated as housing allowance. Once approved by the Board, he’ll receive the $1,500/mo free from income tax. But the entire social security tax falls on him: instead of splitting the 15.3% tax with his employer (each pay 7.65%), Joe has to pay the entire 15.3% himself on the housing allowance as “self employment tax”. But he was paying 22.65%, now effectively reduced to 15.3% on the housing allowance.
So now his monthly pay looks like this:
$ 2,500 salary
-$ 375 income tax (15% of salary)
-$ 191 self employment/social security tax (7.65% of salary)
+$1,500 housing allowance
-$ 230 self employment/social security tax (15.3% of housing allowance)
=$ 796 total tax, saving over $100/mo
Of course this math is over-simplified. I’m just hoping to call your attention to the following issue:
Joe’s employer cannot withhold the $230/mo self employment tax from his paycheck. So if he’s not aware of that and hasn’t been setting that money aside each month, he’s going to owe a whole year’s worth of it the following April 15. That’s almost $2,800! Sure feels like a housing allowance penalty at that point. Poor Joe.
So if you have a housing allowance designation, you need to be saving about 15% of your housing allowance figure just to cover your tax bill.
But it’s worse than that: if you estimate that the total self employment tax for the year will be over $1,000, you have to send tax payments in quarterly. Everyone else has taxes taken out of each paycheck, so the government isn’t going to let you wait until the end of the year either.
The IRS Savings Plan
The one hack I’ve seen is to set up extra withholding when you fill out the W4 for the church. If Joe determines that he should be putting aside $230/mo, he can put that amount on Line 6 “Additional amount, if any, you want withheld from each paycheck”. Of course since he’s paid twice a month, he’ll actually put $115 on Line 6. Cuz he’s smart that way.
If you use this hack, technically your employer will be withholding the money as income tax. Then when you file your taxes you will have an over payment of income taxes in the same amount that you owe on self employment tax and they’ll wash each other out.
Now that you know the right questions to ask, be sure to run your own numbers past your accountant or tax-preparer.