There’s something about the greeter at the local department store. He’s well-spoken and exudes a personal touch that must come from a career made shaking hands and offering kind words with a smile.
As troubling as it may sound, though, he may be a retired pastor under financial pressure to take the job because he had an underperforming retirement plan—or no plan at all.
Who takes the initiative in setting up a retirement plan for pastors? In many cases, the denomination or individual church steps up. If not, the pastor can at least contribute to his or her own Individual Retirement Account (IRA) or make retirement packages part of salary negotiation.
“In a great many churches, the pastors/employees have to be the ones that demand this type of benefit,” says Elaine Sommerville, a CPA in charge of the tax practice of Ratliff & Sommerville, a Texas firm specializing in ministry and nonprofit finances.
A vision with numbers attached
New pastors begin planning for retirement by looking 30 to 40 years into the future, calculating their needs and creating a program that will meet those needs.
According to Richard Hammar, attorney, CPA and senior editor of the Church Finance Today newsletter, this means “deciding how much you will need for living expenses when you retire, and then planning a retirement plan that meet those needs, being sure to include Social Security and any other sources of income.”
The question underlying all the other questions for pastors: How much money will you need?
“In general, most financial planners recommend that you contribute enough to your retirement plan that it, along with Social Security and all other forms of retirement income, will yield between 70 and 100 percent of your pre-retirement income,” Hammar says.
Financial planners use a variety of tools to help pastors calculate their future needs. No one-size-fits-all formula exists, but these questions should be carefully considered and assigned specific dollar amounts:
- How long will I work?
- How will my investments perform?
- What will be my housing arrangements?
- How much debt will I carry?
- What will be my tax burden?
- What will my cost of living be at retirement?
“Then determine whether, at your retirement age, there will be enough money there to fund the standard of living for what you estimate to be the remainder of your life,” says Michael Batts, president of the Florida nonprofit CPA firm Batts, Morrison, Wales and Lee. Any plan should be “prudent and consistent with goals and the risk tolerance of the individual,” he adds.
The level of funding depends greatly on when a plan is set up. Earlier is better.
“Some may believe that annual contributions of, say, $5,000, is a lot. After all, it is more than $400 per month. But, if ministers do not begin deferring this amount into a retirement fund until they are in their 40s or older, it simply is not going to accumulate into a fund large enough to provide adequate retirement income in most cases, especially at the current low rates of return,” Hammar says.
Pieces of a good plan
Retirement plans have a great deal of variety, but the best ones have certain pieces in place that protect the pastor.
First, have a plan that designates a housing allowance each year. This is particularly helpful for pastors who live in parsonages or have had housing allowances as part of their salary packages.
Second, the plan should have maximum flexibility.
“The plan should contain several different financial choices and the participant should be able to move between those options as they progress through the various life stages,” Sommerville says.
Because pastors usually move a few times during their careers, their retirement plans should be portable. Hammar notes that 403(b) plans, the most common retirement plans for ministers, are fully portable. If a pastor leaves, the amount accumulated can move into the next employer’s plan or roll into an IRA.
Third, pastors should get a plan that allows them to make their own additional contributions.
Types of plans
Retirement plans for pastors fall into four general categories.
Qualified plans are so labeled because they qualify for tax deferral. The most common kind of a qualified plan for minis- try employees is the 403(b), also known as a tax-sheltered annuity, where a pastor does not pay taxes on the amount of money contributed in the year the contribution was made. Taxes on any earnings gained from the investment are also tax-deferred.
“At the end of each year, make a salary reduction election for the new year that will be adequate to cover your expected retirement needs,” Hammar says.
Non-qualified plan: These plans do not qualify for tax deferrals. They typically come into play when a pastor has already contributed the maximum amount to a qualified plan and wants to add more. They are funded with employee contributions made through a payroll deduction agreement.
Qualified individual plan: An IRA is the most common type of plan in this category. An individual will set up this kind of account with a bank or an investment company.
“I would tell anybody that the best and first option is a qualified plan that is set up and maintained by the employer,” Batts says. “You get the best tax advantage that way. Qualified plans allow for the largest amount of money that goes in on a tax- favored basis. Larger churches, particularly denominational churches, will typically have this in place at the denominational level. Independent churches will have to do it themselves.”
An option to consider for both IRA and pre-qualified plans is a Roth arrangement, which allows money to be put into the plan on an after-tax basis. The earnings grow on a tax-exempt basis, and withdrawals are not taxed.
“This Roth feature is allowed in the majority of plans and provides huge benefits to those who have many years to contribute to their plans,” Sommerville says.
Another kind of plan, called a nonqualified deferred compensation plan (better known as a rabbi trust), is a specialized plan normally used only after a person has contributed the maximum amount into a qualified plan. In a rabbi trust, the church promises to compensate the pastor at a future date for services performed currently. The trust is funded by a salary reduction agreement, employer contributions, or an unfunded promise to pay the pastor in the future.
One advantage to this kind of plan is that the church’s transfer of funds to the trust is generally not currently taxable. A church can set aside large amounts of money in the trust that exceed the limits imposed by other kinds of retirement plans.
The disadvantage is that the requirements for these plans are stringent and should be set up only with the guidance of expert legal counsel.
“A mistake in this type of plan can not only cause the minister to pay tax on contributions in the year they are contributed to the plan, but it can also carry a penalty of 20 percent,” Sommerville says.
Keeping it legal
The rabbi trust is one example of a church plan, a phrase used to describe a retirement plan established by a church or denomination that is exempt from some of the regulations that apply to similar retirement plans in the private sector.
Whatever plan is chosen, the plan’s administrator and legal counsel need to make sure it follows the law.
“Every plan has a set of rules to follow. Anyone who thinks it just involves setting up a brokerage account or buying an annuity should familiarize themselves with all of the rules surrounding retirement options,” Sommerville says.
Changes in laws will only add to the complexity. For example, a federal court case in California is challenging the constitutionality of housing allowances.
“If the courts ultimately rule that the housing allowance exclusion is unconstitutional, this not only means that churches no longer will be able to declare housing allowances for their ministers, but also that denominational pension plans will not be able to declare the distributions made to retired clergy as nontaxable housing allowances,” Hammar says.
Perhaps the most important legal issue, and one with deep economic consequences as well, deals with how a pastor handles Social Security. It is estimated that one-third of clergy have opted out of Social Security, which means they do not have to pay Social Security taxes on their ministerial earnings.
“This attracts ministers because the economic benefit of electing out saves them so much in taxes,” Batts says.
Opting out also means that the pastors are not building up any Social Security benefits for themselves. Therefore, they are not eligible for Social Security benefits unless they have 40 or more quarters of coverage from secular employment, Hammar explains.
Without Social Security benefits, modest though they may be, the retirement plan is asked to carry that much more weight.
Settling with the taxman
The central tax decision regarding retirement plans is whether to be taxed now or later. Most plans choose to have taxes taken out when funds are withdrawn.
Another tax issue arises when a pastor receives a large retirement gift. The pastor doesn’t usually get to keep all the money. Any payment to a pastor is taxable unless it meets a specific provision in the Internal Revenue Code to exempt it from taxation.
“The bottom line is that churches and pastors should assume that retirement gifts are fully taxable, but understand that in very limited situations it may be possible to argue that they are not. No pastor or church should treat a retirement gift as nontaxable without the advice of legal counsel. In the vast majority of cases, they simply will not be,” Hammar says.
A church and its people may consider a retirement gift in the form of a large contribution to the pastor’s retirement plan. If so, make sure the gift amount does not exceed the limit that may be contributed.
Within reach for your church?
If your church has not established a retirement plan for pastors and staff, the reason may be because it is small and has limited financial resources. However, a plan such as a 403(b) costs the church nothing because it is funded from agreed-upon payroll deductions.
In some cases, pastors are reluctant to bring up the issue for fear it may indicate excessive self-interest or a lack of faith in God’s provision. In other circumstances, a pastor’s retirement plan is simply not on the board’s radar.
“Retirement savings is always a matter of attitude. Since even saving a $1,000 per year starting when you are 20 can create a large retirement account when you are 65, there are few instances that a church cannot ‘afford’ to assist a pastor in this manner,” Sommerville says.
In any organization, the amount of available funds is limited. The same is true for pastors. The matter of funding a retirement plan thus becomes one of choosing priorities.
“The reality is, it’s a need and it should be put on the table,” Batts says. “The church has the option to decide what level of priority to give retirement funding. The pastor has a prioritization issue in choosing which portion of his own pay will be deferred to the plan. Granted, there are so many dollars in the bucket no matter what, but it becomes an issue of priority for both sides.”