One in five pastors do not save for retirement, revealed a National Association of Evangelicals (NAE) survey of more than 4,000 pastors nationwide. And among those who do, they don’t save nearly enough.
Asked about the amounts saved thus far for retirement, whether through individual retirement accounts (IRAs), 403(b) or 401(k) plans, pension funds, or other options, 21 percent said “Nothing.” The median amount for those who have set aside something was a meager $30,000—not nearly enough to cover living expenses for someone who may live 10, 20, or even 30 years after they retire. Perhaps most troubling is that a Barna study showed the median age for a US pastor in 2017 was 54 years old, a sign that many who are heading toward the home stretches of their careers may have little sources of income to live off of after those careers.
And even with 80 percent of respondents from the NAE survey indicating they contribute to Social Security, and expect to draw from it in their retirement years, the outlook isn’t rosy, either. In a report from the board overseeing Social Security and other entitlement programs, the funds needed for these programs will be depleted by 2034 (based on October 2016 projections) unless major reform occurs soon. That puts even more pressure on retired pastors to draw income from other sources, such as retirement plans—and that pressure further intensifies for those pastors who opted out of Social Security.
The bottom line: pastors—and the churches that employ them—must think strategically about retirement savings as a way to avoid severe financial hardship.
Evaluating retirement plan options
Several kinds of tax-favored retirement plans are available to pastors through either their employing church or a denominational plan. A “tax-favored” plan has the following two characteristics:
1. contributions made by a church to a pastor’s account are excludible for income tax purposes in the year of contribution, and
2. the income (or appreciation) earned on the account is tax-deferred, meaning that it is not taxable until distributed—and even then contributions and earnings may not be taxable if a pastor is entitled to a retiree housing allowance (discussed later in this article).
These plans may be funded with pastor contributions (typically through salary reductions), by contributions from the church, or by a combination of the two.
Ministers can accumulate substantial retirement funds by using tax-deferred retirement plans. How much is accumulated depends on three variables: the amount of the annual contributions to the plan, the rate of return, and the number of years of participation. This chart illustrates what a pastor can accomplish through an annual $3,000 contribution ($250 per month) toward retirement, whether 20, 30, or 40 years away from retirement; whether achieving low, modest, or high rates of return, depending on market conditions; and, whether the pastor opts for a tax-deferred retirement plan (the highlighted column on the far right).
As the chart shows, the deferral of tax on income generated by a retirement plan can result in significant accumulations of funds for retirement, especially if contributions begin early and are made systematically. Younger pastors should discipline themselves to participate in such plans at as early an age as possible, since the value of their contributions will be magnified over time. But pastors further into their careers also can make significant progress and should be encouraged to save as much as they can afford, and to do so as soon as possible.
Types of retirement help
This article addresses the following types of church- or denominational-sponsored retirement plans:
- tax-sheltered annuities (403(b) plans);
- qualified pension plans; and
- deferred compensation plans, including rabbi trusts.
Beyond sponsoring retirement plans, there are two other significant ways that churches can financially help pastors with their retirements. The first is the housing allowances that churches, church benefits boards, or other qualified organizations can designate for retired pastors, which represent a significant tax savings for pastors—if certain conditions are met. Chapters 6 and 10 of the Church & Clergy Tax Guide offer further insights on this front.
The other is a lump-sum retirement gift made by a congregation to a retiring pastor. Sometimes the gift is paid out in monthly installments. Ordinarily, these gifts constitute taxable compensation rather than a tax-free gift. Chapter 4 of the Church & Clergy Tax Guide further explains the tax implications of various retirement gift arrangements.
Before reviewing possible plans, churches must understand the terminology related to the term church plan, since it has significant effects on rules and exemptions that may or may not apply to the plans or the pastors who participate in them. A plan maintained by a local church is going to be a church plan. Leaders should know that the ongoing litigation involving church plans sponsored by hospital systems will not affect a church plan they oversee for their local congregation.
The tax code uses the term church plan in several contexts, including the following:
• Section 79(d)(7) exempts church plans from the nondiscrimination rules that apply to the exclusion of up to $50,000 of employer-provided group term life insurance.
• Section 410(d) of the tax code permits an election to be made under which a church plan would be subject to the same requirements as apply to other qualified plans (electing church plan). Section 1.410(d)-1 of the income tax regulations provides that the election is irrevocable and may be made only by the plan administrator and only in the manner provided in the regulations. If the election is made, the plan must comply with the applicable provisions of the tax code. In addition, an electing church plan would be covered by and subject to Title I and, if a defined benefit pension plan, Title IV of the Employee Retirement Income Security Act of 1974 (ERISA).
• Section 4980D exempts church plans from the penalty that applies to group health plans that discriminate in favor of highly compensated employees.
• Section 1402(a)(8) specifies that net earnings from self-employment (in computing the self-employment tax) does not include “the rental value of any parsonage or any parsonage allowance … provided after the individual retires, or any other retirement benefit received by such individual from a church plan (as defined in section 414(e)) after the individual retires.”
• Section 415(c)(7) provides that church employees who participate in a church plan can elect an alternative amount for the limit on annual additions. Under this election, employees can contribute up to $10,000 a year to a tax-qualified retirement plan, even if nothing can be contributed under the regular 415(c) limit. Total contributions over one’s lifetime under this election cannot be more than $40,000.
• The nondiscrimination rules that apply to 403(b) plans do not apply to church 403(b) plans.
• The instructions for the current IRS Form 5500 state that church plans not electing ERISA coverage under section 410(d) of the tax code are not required to file Form 5500.
Under section 4(b)(2) of ERISA, a “non-electing” church plan is excluded from coverage under Title I of ERISA. This means it is not subject to ERISA’s rules governing reporting, disclosure, and fiduciary conduct. In the case of a defined benefit pension plan, the plan is also not covered by the insurance provisions of Title IV of ERISA, which provides for certain benefit guarantees by the Pension Benefit Guaranty Corporation (PBGC) in the event of termination of an underfunded pension plan. This means the plan is not required to pay PBGC premiums.
A non-electing church plan is instead primarily subject to certain qualification requirements that predate the enactment of ERISA. The plan is treated as a tax-qualified plan only if the plan satisfies the participation, vesting, and funding requirements of the tax code as in effect prior to ERISA. Section 514(a) of ERISA generally provides that ERISA supersedes state laws that relate to an employee benefit plan described in section 4(a) of ERISA and not exempt under section 4(b) of ERISA. A non-electing church plan is exempt under section 4(b) of ERISA. Thus, state laws that relate to an employee benefit plan generally would apply to the non-electing church plan.
Section 410(d) of the tax code permits an election to be made under which a church plan would be subject to the same requirements as apply to other qualified plans (electing church plan). Section 1.410(d)-1 of the income tax regulations provides that the election is irrevocable and may be made only by the plan administrator and only in the manner provided in the regulations. If the election is made, the plan must comply with the applicable provisions of the tax code. In addition, an electing church plan would be covered by and subject to Title I and, if a defined benefit pension plan, Title IV of ERISA.
Key Point. The major advantage derived by a plan that qualifies as a church plan is that it allows the plan sponsor flexibility in complying with the participation, vesting, and funding requirements imposed by the code. As well as being exempt from certain provisions of the tax code, church plans are exempt from Titles I and IV of ERISA.
Let’s look at the most common options available to pastors.
1. 403(b) plans
One of the most popular retirement plans for church employees is the 403(b) plan (sometimes called a tax-sheltered annuity). Such plans permit employees of churches and other public charities to make nontaxable contributions to their 403(b) account up to the allowable limits prescribed by law. In addition, earnings and gains on 403(b) accounts are tax-deferred, meaning that they are not taxed until distributed.
When section 403(b) accounts were first introduced in 1958, the only investment option available to employees was an annuity (hence the name tax-sheltered annuity). In 1974, Congress added section 403(b)(7) to the tax code. This section allows employees of churches and other charities to invest their 403(b) account with a mutual-fund company. These types of 403(b) plans are called 403(b)(7) accounts or custodial accounts. In 1982, Congress added section 403(b)(9)to the tax code, which recognizes retirement income accounts of churches as yet another kind of 403(b) plan. Such accounts may be invested in annuities or mutual funds, and they usually are. But they are not limited to these investments.
To summarize, a 403(b) plan can be any of the following types:
- an annuity contract, described in section 403(b)(1) of the tax code, which is a contract provided through an insurance company;
- a custodial account, described in section 403(b)(7) of the tax code, which is an account invested in mutual funds; or
- a retirement income account, described in section 403(b)(9) of the tax code, which is set up for church employees.
Although 403(b) plans established by churches can be of any of these three types, there are three reasons many churches establish the third kind of 403(b) plan (a 403(b)(9) retirement income account). First, these accounts were designed for church employees. Second, the investment options are more flexible, since church retirement income accounts are not restricted to investing in annuities and regulated mutual funds. And third, if a church participates in a denominational 403(b)(9) plan, the pastor also may be able to receive benefits payable as an annuity under the program.
A 403(b) plan has several tax advantages:
- You do not pay tax on contributions to your 403(b) plan in the year they are made. You do not pay tax on them until you begin making withdrawals from the 403(b) plan, usually after you retire.
- Earnings and gains on your 403(b) plan are not taxed until you withdraw them, usually after you retire.
- You may be eligible to claim a “qualified retirement savings” tax credit for contributions to your 403(b) plan made by salary reduction.
- Elective contributions (through salary reduction) to a 403(b) plan do not constitute self-employment earnings in computing the self-employment tax liability of a minister.
- Churches and church pension boards that offer 403(b) plans can designate a portion of a retired minister’s distributions as a tax-excludible housing allowance.
Only a qualified employer can maintain a 403(b) plan. Tax-exempt organizations, including churches and most other religious and charitable organizations, are considered qualified employers, as are employers that are not tax-exempt but that employ a minister serving outside of a local church to perform ministerial services.
The following employees are eligible to participate in a 403(b) plan:
• Employees of tax-exempt organizations established under section 501(c)(3) of the tax code (this includes employees of religious organizations and schools).
• Pastors employed by section 501(c)(3) organizations.
• A self-employed pastor is treated as employed by a tax-exempt organization that is a qualified employer. The earned income of a self-employed pastor becomes their compensation for purposes of calculating permissible contributions to a 403(b) plan, and a self-employed minister “shall be treated as his or her own employer which is an organization described in section 501(c)(3) and exempt from tax.” This is an exception to the general rule that only employees of 501(c)(3) organizations are eligible to participate in a 403(b) plan.
• Ministers (chaplains) who meet both of the following requirements: (1) they are employed by organizations that are not section 501(c)(3) organizations, and (2) they function as ministers in their day-to-day professional responsibilities with their employers. But note that chaplains cannot contribute both to a denominational retirement plan and to their employer’s plan from salary paid by his or her employer—they can only contribute to one.
Funding a 403(b)
A 403(b) plan can be funded by the following contributions:
Elective deferrals. These are contributions made under a salary reduction agreement. This agreement allows a church to withhold money from the pastor’s paycheck to be contributed directly into a 403(b) account for the pastor’s benefit. Except for Roth contributions, a pastor does not pay tax on these contributions until he or she withdraws them from the account. If the pastor’s contributions are designated as Roth contributions, the pastor pays taxes on the contributions, but any qualified distributions from the Roth account are tax-free.
Key Point. A pastor may want to designate a portion of his or her contributions as Roth contributions, even though the pastor will be entitled to a tax-excludible housing allowance in retirement. This is because the pastor may need to receive a sizable retirement plan distribution in order to make a down payment on a retirement home—and the housing allowance rules only allow part of such a down payment to be tax-excludible.
Nonelective contributions. These are church contributions that are not made under a salary reduction agreement. Nonelective contributions include matching contributions, discretionary contributions, and mandatory contributions from a church. The pastor does not pay tax on these contributions until he or she withdraws them from the account.
After-tax contributions. These are contributions (that are not Roth contributions) a pastor makes with funds that the pastor must include as income on his or her tax return. A salary payment on which income tax has been withheld is a source of these contributions. If the pastor’s plan allows him or her to make after-tax contributions, the pastor cannot deduct them on his or her tax return.
Combination. A combination of any of the three contribution types listed above.
Generally, the maximum amount contributable (MAC) is governed by (1) the limit on annual additions (the total of employer contributions and employee elective deferrals in a year) or (2) the separate limit on elective deferrals. Note the following:
Limit on annual additions
The overall limit on annual additions is the limit on the total contributions that can be made to the pastor’s 403(b) plan each year. For 2017, it is the lesser of $54,000 or 100 percent of includible compensation for the pastor’s most-recent year of service. IRC 415(c). The $54,000 amount is indexed for inflation in $1,000 increments.
Limit on elective deferrals
In addition to the overall limit, for 2017, an employee cannot elect to defer more than $18,000 a year from salary. The limit on elective deferrals also is indexed for inflation.
Includible compensation is defined by the tax code as “the amount of compensation which is received from the employer … and which is includible in gross income … for the most recent period (ending not later than the close of the taxable year). … Such term does not include any amount contributed by the employer for an annuity contract to which this subsection applies.” IRC 403(b)(3).
Includible compensation also includes (1) elective deferrals (the church’s contributions made on the pastor’s behalf under a salary reduction agreement); (2) amounts contributed or deferred by a church under a section 125 cafeteria plan; (3) wages for personal services earned with the church that maintains the 403(b) plan; and (4) income otherwise excluded under the foreign earned income exclusion.
Does the term includible compensation include a pastor’s housing allowance? Based on the tax code and IRS guidance, the definition of includible compensation for purposes of computing the limit on annual additions to a 403(b) plan would not include the portion of a pastor’s housing allowance that is excludable from gross income, or the annual rental value of a parsonage.
Additional limits and special rules apply to MAC calculations. Chapter 10 of the Church & Clergy Tax Guide provides these details, including help with making calculations.
The limit on elective deferrals under a 403(b) plan is increased for individuals who have attained age 50 by the end of the year.
The additional amount of elective contributions that may be made by an eligible individual participating in such a plan is the lesser of (1) the “applicable dollar amount” or (2) the excess of your compensation for the year over the elective deferrals that are not catch-up contributions.
Catch-up contributions are not subject to any other contribution limits and are not taken into account in applying other contribution limits.
When figuring allowable catch-up contributions, combine all catch-up contributions made by your employer on your behalf to the following plans:
- qualified retirement plans,
- 403(b) plans,
- simplified employee pension (SEP) plans, and
- SIMPLE plans.
The total amount of the catch-up contributions on your behalf to all plans maintained by your employer cannot be more than the annual limit.
Use Worksheet C in IRS Publication 571 to compute your catch-up contributions.
There also is an additional special limit increase available under a 403(b) plan for pastors who have had 15 years of service with their church. Service with other churches in the same denomination can be aggregated to satisfy the 15-year requirement. Generally, under this special rule, pastors can contribute up to an additional $3,000 per year above the $18,000 salary deferral limit, with a lifetime limit of $15,000 in these additional catch-up contributions.
Key Point. If you are eligible for both the 15-year rule increase in elective deferrals and the age-50 catch-up, allocate amounts first under the 15-year rule and next as an age-50 catch-up.
Key Point. The age-50 catch-up contributions are not counted against a pastor’s MAC. The special 15 years of service contributions do count toward the MAC. Therefore, the maximum amount that a pastor is allowed to have contributed to his or her 403(b) account is the MAC plus the allowable age-50 catch-up contribution.
If your actual contributions are greater than your MAC, you have an excess contribution. Excess contributions can result in additional taxes and penalties.
Voluntary employee contributions
As noted above, a pastor cannot deduct voluntary after-tax employee contributions made to his or her 403(b) plan. However, if contributions are made on a salary-reduction basis and meet the requirements of the 403(b) regulations, the amounts are currently excludible from income.
Contributions and Social Security
Note the following rules:
IRS Publication 517 instructs ministers, when computing self-employment taxes: “Do not include … contributions by your church to a tax-sheltered annuity plan set up for you, including any salary reduction contributions (elective deferrals), that are not included in your gross income.” See also Revenue Ruling 68-395 and Revenue Ruling 78-6.
Further, section 1402(a)(8) of the tax code specifies that “an individual who is a duly ordained, commissioned, or licensed minister of a church … shall not include in net earnings from self-employment the rental value of any parsonage or any parsonage allowance (whether or not excludable under section 107) provided after the individual retires, or any other retirement benefit received by such individual from a church plan after the individual retires” (emphasis added).
Reporting contributions on tax returns
Churches must report 403(b) contributions on a pastor’s W-2. Chapter 10 of the annual Church & Clergy Tax Guide provides details on this reporting.
Generally, a distribution cannot be made from elective deferrals made to a 403(b) plan until the employee
- reaches age 59½,
- has a severance from employment,
- becomes disabled, or
- encounters financial hardship.
Distributions prior to age 59½ that do not satisfy one of the above exceptions, or are made before an individual reaches age 55 and terminates employment, are subject to an additional “tax on early distributions” of 10 percent multiplied by the amount of the distribution.
Although the term hardship is not defined in section 403(b) of the tax code, the IRS applies the same definition and rules to hardship distributions from 403(b) plans that apply to 401(k) plans. In that context, it is defined as a distribution that “is made on account of an immediate and heavy financial need of the employee and is necessary to satisfy the financial need. The determination of the existence of an immediate and heavy financial need and of the amount necessary to meet the need must be made in accordance with nondiscriminatory and objective standards set forth in the plan.” Treas. Reg. 1.401(k)-1(d)(2)(i). This definition probably is relevant in construing the same term under section 403(b).
In most cases, the payments a pastor receives or that are made available to the pastor under his or her 403(b) plan are taxable in full as ordinary income—unless, of course, the pastor can claim a retiree housing allowance with respect to all or part of such payments. In general, the same tax rules apply to distributions from 403(b) plans that apply to distributions from other retirement plans.
A pastor cannot keep retirement funds in his or her 403(b) account indefinitely. A pastor has to start taking withdrawals upon the later of: (1) when he or she reaches age 70½ or (2) when he or she retires. The question of when a pastor is “retired” for this purpose is not clearly defined. The IRS has informally indicated that, while it will not define what retirement is for this purpose, a position taken by a church that is consistent with its governing documents and is consistently applied will not be challenged. Churches and pastors should consult qualified legal counsel for more specifics about the meaning of “retirement” for 403(b) plan purposes.
The required minimum distribution (RMD) is the minimum amount the pastor must withdraw from his or her account each year.
- A pastor can withdraw more than the minimum required amount.
- The pastor’s withdrawals will be included in his or her taxable income except for any part that was taxed before (referred to as the pastor’s “basis”).
Beginning date for a pastor’s first RMD for a 403(b) account is April 1 following the later of the calendar year in which the pastor:
- reaches age 70½ or
The pastor reaches age 70½ on the date that is six calendar months after his or her 70th birthday.
Calculating the RMD can be difficult. The IRS website (IRS.gov) contains a calculator that simplifies this calculation.
If an account owner fails to withdraw an RMD, fails to withdraw the full amount of the RMD, or fails to withdraw the RMD by the applicable deadline, an additional 50 percent excise tax must be paid.
403(b)(7) custodial accounts
As mentioned above, in 1974 Congress added section 403(b)(7) to the tax code. This section allows employees of churches and other charities to invest their 403(b) account with a mutual-fund company. 403(b)(7) plans are different than 403(b)(1) annuity plans or 403(b)(9) retirement accounts in one important respect—both employer contributions and employee elective deferrals are subject to the distribution restrictions on elective deferrals, previously described.
Caution If a church participates in a denominational 403(b) plan and also contributes on behalf of a pastor or other church worker separately to a 403(b) arrangement offered by another 403(b) provider, the church is required to apply the 403(b) rules on an aggregated plan basis. For example, if the pastor takes a loan out from the denominational plan and also from the other provider’s 403(b) arrangement, both loans must be aggregated for purposes of satisfying the tax code’s limit on retirement plan loans.
A pastor can generally roll over, tax-free, all or any part of a distribution from a 403(b) plan to a traditional IRA or an eligible retirement plan except for any nonqualifying distributions. The most a pastor can roll over is the amount that, except for the rollover, would be taxable. The rollover must be completed by the 60th day following the day on which the pastor receives the distribution. The IRS may waive the 60-day rollover period if the failure to waive such requirement would be against equity or good conscience, including cases of casualty, disaster, or other events beyond the reasonable control of the individual. To obtain a hardship exception, a pastor formerly had to apply to the IRS for a waiver of the 60-day rollover requirement, however the IRS has issued guidance that now permits a participant to self-certify that the required conditions exist for a waiver of this requirement.
Distribution from a designated Roth account can only be rolled over to another Roth account.
A pastor can roll over, tax-free, all or any part of a distribution from an eligible retirement plan to a 403(b) plan. If a distribution includes both pre-tax contributions and after-tax contributions, the portion of the distribution that is rolled over is treated as consisting first of pre-tax amounts (contributions and earnings that would be includible in income if no rollover occurred). This means that if a pastor rolls over an amount that is at least as much as the pre-tax portion of the distribution, the pastor does not have to include any of the distribution in income.
The following are considered eligible retirement plans: IRAs, Roths, qualified retirement plans, 403(b) plans, and eligible governmental 457 plans (except Roth contributions and earnings on such contributions can only be rolled over to a Roth IRA). A pastor cannot roll over, tax-free, any of the following nonqualifying distributions: required minimum distributions, substantially equal payments over the pastor’s life or life expectancy, substantially equal payments over the joint lives or life expectancies of the pastor’s beneficiary and the pastor, substantially equal payments for a period of 10 years or more, or hardship distributions.
Caution Pastors rolling money out of a denominational 403(b) arrangement or other 403(b) arrangement provided by their employing church into an IRA (or other eligible plan) need to understand that the new financial provider will not be able to designate a housing allowance on payments made from the new arrangement.
A 403(b) plan established and maintained by a church is not subject to coverage and nondiscrimination rules, including the so-called “universal availability” rule related to employee elective deferrals.
In 2004, the IRS published proposed regulations that provided the first comprehensive guidance on the administration of 403(b) plans in 40 years. The IRS was prompted to act as a result of the massive noncompliance it uncovered in field audits of 403(b) plans. Following publication of the 2004 proposed regulations, comments were received and a public hearing was held. The regulations were adopted as final regulations in 2007. The final regulations took effect on January 1, 2009, for most tax-exempt organizations.
What is the relevance of the 403(b) regulations to churches? Section 403(b) retirement plans are perhaps the most common form of retirement plan for church employees, so it is essential for church leaders to be familiar with the application of the regulations to their 403(b) plan. Failure to comply with the regulations may result in adverse tax consequences.
The provisions in the final regulations of most relevance to churches are summarized below.
Written plan requirement
The final regulations require a 403(b)(9) retirement income account to have a formal written plan document that satisfies the requirements of section 403(b) and the regulations. This means that a plan document must address several issues, including the following:
- employee eligibility,
- contribution limits,
- salary reductions,
- investments (fund providers available under the plan),
- hardship withdrawals, and
- allocation of compliance responsibilities to employers and fund providers (vendors).
In addition, the plan document must state (or otherwise evidence in a similarly clear manner) the intent to constitute a 403(b)(9) retirement income account.
Churches sponsoring a 403(b)(1) or a 403(b)(7) type of plan, however, are not required to have a written plan document. (As noted above, 403(b)(1) plans are provided by insurance companies providing annuities, while 403(b)(7) plans are provided by mutual fund financial service providers.)
The final regulations note that a 403(b) plan is permitted to allocate to the employer or to one or more third parties (e.g., investment companies) the responsibility for compliance with section 403(b) and the regulations. Any such allocation must identify who is responsible for compliance with the requirements of section 403(b), including loans and hardship withdrawals. However, the final regulations assert that it is generally inappropriate to allocate these responsibilities to employees.
The final regulations permit the plan to incorporate by reference other documents (including salary-reduction agreements, contracts, and policies) which, as a result of such reference, would become part of the plan. As a result, a plan may include a wide variety of documents, but it is important for the employer adopting the plan to ensure that its plan does not conflict with other documents that are incorporated by reference. If a plan does incorporate other documents by reference, then, in the event of a conflict with another document, except in rare and unusual cases, the plan would govern.
For further assistance
Churches that are affiliated with a denomination that offers a 403(b) plan should check with their denominational plan for compliance-related questions. Churches that offer 403(b) plans through one or more commercial mutual fund or investment firms should check with those vendors for assistance. In addition, the IRS website (IRS.gov) contains a section devoted to compliance with the regulations.
Church pastors may wish to establish individual retirement arrangements (IRAs) on either a Roth or a non-Roth basis. Regarding IRAs, the IRS explains:
Two tax advantages of an IRA are that:
Contributions you make to an IRA may be fully or partially deductible, depending on which type of IRA you have and on your circumstances, and
Generally, amounts in your IRA (including earnings and gains) are not taxed until distributed. In some cases, amounts are not taxed at all if distributed according to the Roth IRA rules.
Eligibility to claim a deduction for traditional IRA contributions depends on whether you are an active participant in an employer-sponsored plan in the year to which your deduction applies. If neither you nor your spouse is an active participant, you may deduct your full contribution for the year, up to the IRA contribution limit. If, however, you are an active participant, your tax-filing status and modified adjusted gross income determine your eligibility to deduct your IRA contribution.
Regarding Roth IRAs, the IRS explains:
A Roth IRA is an individual retirement plan that, except as explained in this article, is subject to the rules that apply to a traditional IRA. It can be either an account or an annuity… . To be a Roth IRA, the account or annuity must be designated as a Roth IRA when it is opened… . Unlike a traditional IRA, you cannot deduct contributions to a Roth IRA. But, if you satisfy the requirements, qualified distributions are tax-free. Contributions can be made to your Roth IRA after you reach age 70&frac; and you can leave amounts in your Roth IRA as long as you live… . You can open a Roth IRA at any time. However, the time for making contributions for any year is limited.
IRAs and Roth IRAs are fully explained in IRS Publication 590, which can be downloaded from the IRS website (IRS.gov).
3. Qualified pension plans
Some churches and religious denominations have established qualified pension plans described in tax code section 401(a) to finance retirement benefits for their employees. The best-known type of qualified section 401(a) plan is a 401(k) plan. Such plans enjoy several tax benefits, including the following: (1) the employer gets an immediate tax deduction for contributions to the plan (this benefit is, of course, not relevant to tax-exempt churches and religious organizations), (2) fund earnings are tax-exempt, (3) employees are not taxed on their share of the fund until they receive distributions, (4) qualifying distributions can be rolled over tax-free to another plan or IRA, and (5) an employee can elect to have benefits payable to a designated beneficiary after his or her death without incurring gift tax liability.
These various tax benefits are available only if the plan is qualified. Qualification means that the plan satisfies the several conditions enumerated in section 401 of the tax code. Some of the more important requirements for qualification include the following:
(1) the plan must be a written program that is communicated to all employees; (2) the plan must be for the exclusive benefit of employees and their beneficiaries; (3) if the plan is a defined benefit or money-purchased pension plan, it must be properly funded; (4) the plan must begin making payments no later than a specified date; (5) contributions and benefits may not exceed specified limitations; (6) certain employees must be permitted to participate in the plan; and (7) an employee’s interest in the plan must generally vest within a specified time. Additional requirements apply to plans benefiting owner-employees and certain “top-heavy” plans (i.e., plans that disproportionately benefit highly compensated employees).
Church plans are exempt from the minimum participation, vesting, funding, and nondiscrimination requirements of ERISA and the tax code unless they elect to be covered. IRC 410. Such an election is irrevocable. As described previously, tax code section 414(e) defines the term church plan as a plan “maintained for its employees by a church.” The income tax regulations clarify that, for purposes of this definition, the term church includes “a religious organization if such organization (1) is an integral part of a church, and (2) is engaged in carrying out the functions of a church, whether as a civil law corporation or otherwise.” Treas. Reg. § 1.414(e)-1(e).
Qualified pension plans can be either defined benefit or defined contribution plans. In a defined benefit plan, each employee is promised specified benefits upon retirement, either for a term of years or for life, based upon such factors as years of service and amount of compensation earned. Employer contributions are actuarially calculated to provide the promised benefits and are not allocated to individual accounts for each employee. In a defined contribution plan, the employer does not promise specified benefits to the employees. Rather, the employer makes discretionary or required contributions to the plan, as selected by the employer. Such contributions must be allocated to individual accounts for each employee. Retirement benefits are whatever can be provided by the accumulated employer contributions plus any earnings.
The establishment of a qualified pension plan obviously is a complex task that should be handled by an attorney having experience with employee benefits. While IRS approval of a newly established qualified pension plan is not required, it ordinarily is advisable. Often employee pension plans are established by adopting a master or prototype plan previously approved by the IRS.
The instructions for the current IRS Form 5500 state that church plans not electing ERISA coverage under tax code section 410(d) are not required to file Form 5500.
A plan cannot be a qualified plan if it provides for contributions or benefits in excess of specified amounts. A defined benefit plan cannot provide annual benefits that exceed the lesser of $270,000 (for 2017) or 100 percent of an employee’s average compensation for his or her highest three years. (Church plans are not subject to the 100 percent of taxable compensation limit.) Contributions (and any other additions) to a defined contribution plan must not exceed the lesser of $54,000 or 100 percent of an employee’s compensation for 2017.
As is the case with 403(b) plans, self-employed pastors and chaplains also can participate in 401(a) tax-qualified plans.
4. Deferred compensation plans
Generally, it is desirable to defer current income to future years when your income and tax rates may be lower. As described above, this is commonly done through various “qualified” plans such as a 403(b), 401(k), or IRA. But persons who have contributed the maximum amount to a qualified plan through salary reduction may want to defer more income to the future, and this is often accomplished through a nonqualified deferred compensation (NQDC) plan that consists of a promise by an employer to pay an employee (or self-employed person) compensation in the future in exchange for services performed currently. The term nonqualified means that the plan is not subject to the many conditions that apply to qualified benefit plans under section 401 of the tax code. However, such plans are subject to the requirements of tax code section 409A, discussed below.
NQDC arrangements can be funded through salary reduction agreements or employer contributions, or they can be unfunded (a mere unsecured promise by the employer to pay future benefits). In either case, such arrangements ordinarily are attractive only if contributions made by or on behalf of an employee are not currently taxable and earnings can accumulate tax-free. In order to ensure that an employee is not taxed currently under a NQDC arrangement, the assets of the plan must be subject to the reach of the employer’s creditors.
Congress added section 409A to the tax code in 2004 to address what it perceived to be certain abuses involving NQDCs. Examples of NQDCs covered by section 409A include some severance agreements, salary deferral agreements, and deferred compensation programs for directors, that provide for the payment of compensation beyond the current year.
In 2007, the IRS published final regulations interpreting section 409A. The final regulations define an NQDC broadly, to include any plan that provides for the deferral of compensation, with some exceptions. This definition is broad enough to include rabbi trusts and some other kinds of church compensation arrangements.
One of the advantages of an NQDC plan is that employees can make larger tax-deferred contributions than are possible under a 403(b), 401(k), or IRA (subject, of course, to the requirement that the tax deferrals plus other compensation is reasonable). However, these advantages come with risks, including the possibility of losing much or all of the deferred compensation. In addition, the 409A rules impose other rules on employee tax-deferred contributions which must be met to avoid current taxation of these contributions. However, if deferred compensation meets the requirements of section 409A, there is no effect on an employee’s taxes. The compensation is taxed in the same manner as it would be if it were not covered by section 409A.
If the arrangement does not meet the requirements of section 409A, the compensation is subject to certain additional taxes, including a 20 percent additional income tax. Section 409A has no effect on the FICA (Social Security and Medicare) tax.
Key Point. What requirements does section 409A of the tax code impose on NQDC plans? There are several, and they are highly complex. Church leaders contemplating the deferral of compensation that an employee earns in the current year to a future year should address the following four points:
- If your church is considering the deferral of compensation for an employee beyond the current year, such as in a severance agreement or rabbi trust, you need to understand that complex rules now apply to such arrangements (” deferred compensation plans”), and the employee may be subject to significant penalties (including back taxes, plus a 20-percent tax) if the complex requirements enumerated in section 409A of the tax code are not met.
- Penalties may be avoided if a deferral arrangement meets the requirements of section 409A.
- As a result, any church contemplating the deferral of an employee’s compensation to a future year should first consult with a tax professional for assistance in complying with the section 409A requirements.
- Section 409A contains some exemptions that may apply, depending on the facts and circumstances. A tax professional can assist in evaluating the possible application of these exemptions.
Key Point. If a church wants to provide a pastor with a substantial retirement contribution upon the pastor’s retirement, a NQDC can be used for that purpose. However, it also may be possible to have the church make additional post-employment contributions to the church’s 403(b) plan in the amount desired for up to five years following the pastor’s retirement. Churches and pastors should also discuss this possibility with qualified tax counsel.
In 1992, the IRS acknowledged that it received a flood of private ruling requests by employers seeking IRS approval of their rabbi trust arrangements. In response, it published a model rabbi trust agreement. Revenue Procedure 92-64. The IRS observed:
The model trust provided in this revenue procedure is intended to serve as a safe harbor for taxpayers that adopt and maintain grantor trusts in connection with unfunded deferred compensation arrangements. If the model trust is used in accordance with this revenue procedure, an employee will not be in constructive receipt of income or incur an economic benefit solely on account of the adoption or maintenance of the trust. However, the desired tax effect will be achieved only if the nonqualified deferred compensation arrangement effectively defers compensation.
The IRS warned that it will not issue any rulings on NQDCs that “use a trust other than the model trust.” In other words, churches and other religious employers that have adopted rabbi trust arrangements should ensure that the language used in their trusts is identical to that in the model IRS form. The IRS cautioned: “The model language must be adopted verbatim, except where substitute language is expressly permitted… . Of course, provisions may be renumbered if appropriate, language in brackets may be omitted, and blanks may be completed. In addition, the taxpayer may add sections to the model language provided that such additions are not inconsistent with the model language.”
A rabbi trust can be an effective tool for churches and religious organizations, especially for highly compensated ministers who are nearing retirement age. Through proper drafting, it is possible for a church to set aside amounts in trust that would exceed the limits associated with other retirement plans. But keep the following points in mind:
- 409A. The NQDC associated with the rabbi trust must meet the requirements of section 409A.
- Assets. The trust must provide that the trust assets are subject to the general creditors of the employer under both federal and state law. This is the most significant disadvantage of a rabbi trust and distinguishes it from many other tax-favored retirement plans.
Example A church establishes a rabbi trust for its senior pastor. Over several years the trust accumulates $250,000. The church is sued as a result of the sexual misconduct of a volunteer worker, and a court awards the victim $1 million in damages. The church’s insurance only covers $100,000 of this amount. The victim has the legal right to compel the church to turn over the rabbi trust to her, thereby eliminating the pastor’s retirement funds.
- Beneficiary. The beneficiary (i.e., the minister) cannot have any legal interest in the trust fund until the trust assets are distributed. The trust should specify that the beneficiary’s interest cannot be assigned, transferred, or used as collateral, and it is not subject to his or her creditors prior to distribution. The idea is this: the beneficiary cannot be taxed on the employer’s transfer of funds to the rabbi trust, since the beneficiary has no interest in the funds and may never receive them should the employer become insolvent.
- Funding. The trust must be funded with the employer’s assets. It is unclear whether a rabbi trust can be funded, in whole or in part, with an employee’s own compensation (such as through a salary reduction agreement). In a 1997 ruling, the IRS did conclude that a rabbi trust could be funded through “salary deferrals” that were executed by employees prior to the beginning of the year in which the salary was earned. IRS Letter Ruling 9703022. However, as mentioned above, salary deferrals must meet the 409A rules applicable to such deferrals in order for them to not be taxable currently.
Any church or other organization that is considering a rabbi trust (or any other arrangement that defers compensation to a future year) should contact an attorney to have the arrangement reviewed to ensure compliance with both section 409A and the final 409A regulations. Such a review will protect against the substantial penalties the IRS can assess for noncompliance. It also will help clarify whether a deferred compensation arrangement is a viable option in light of the limitations imposed by section 409A and the final regulations.
Special thanks to attorney Danny Miller, an editorial advisor for Church Law & Tax, who reviewed this article and provided numerous helpful additions, changes, and clarifications. Miller is a partner in the Washington, D.C., office of Conner & Winters, LLP.