To Opt Out or Not to Opt Out (Part 1 of 2)

To Opt Out or Not to Opt Out (Part 1 of 2)
By Mark Helland, CPA

Mark Helland, CPA is a partner with the accounting firm of Elliott, Dozier and Helland, PC which is located in Tulsa, Oklahoma. For further information on this topic, Mark’s firm has a short report on basic fraud prevention tactics which is available to you at no cost. Mark can be contacted via email at mark@edandhcpa.com or by phone at (918) 627-2286.

Pastors have several key tax issues that make them uniquely different from other American taxpayers, including the housing allowance, self-employed treatment for W-2 wage earners and the ability to opt out of the social security system. These three issues create a great deal of complexity for pastors as they make decisions that have long-ranging consequences for their financial well being. In my view, the ability to elect to irrevocably opt out of social security is the most complex financial planning issue for pastors as it carries a high degree of long-term consequence if the wrong decision is made.

As a quick overview, pastors are considered to be self-employed for tax purposes even though they receive a W-2 from their church or ministry and are then responsible for the payment of what is called self-employment tax. SE tax is a combination of both the “employee” and the “employer” portion of FICA and Medicare tax, both of which the self employed individual is responsible for remitting. This tax is in addition to regular federal income tax on W-2 earnings as the SE tax is paid to the social security system for the future payment of social security benefits at retirement. While the income tax is assessed only on the pastor’s salary or wage income issued on form W-2, SE tax is assessed on salary or wage income and the full amount received as housing allowance. A mistake we frequently see in our practice is the misunderstanding that the housing allowance is completely free from tax. This is only potentially true for those pastors who have opted out of the social security system and for pastors who have not opted out of social security; the housing allowance is subject to SE tax. Of course, any excess housing allowance above actual housing expenses is subject to regular income tax for all pastors, regardless of whether or not the pastor has elected to opt out of social security or not.

The federal government has historically allowed pastors to opt out of the social security system based on religious opposition to being included in a federally operated insurance program. This is the only valid reason that a pastor can cite to make the election to opt out of the system. The election to opt out of social security is made by completing an IRS Form 4361 which is then filed with the IRS as an irrevocable election. It should be noted that this election only pertains to pastoral income and not earned income from other sources such as part-time employment or a separate business activity. During the past thirty or so years, the social security administration offered two brief time windows for pastors to essentially opt back in to the system but this opportunity is not currently available and there is no indication that this opportunity will ever be offered again.

From my experience in working with pastors who have made the election to opt out of social security, I have very rarely sensed that they did so for religious reasons or for opposition to being included in a federal insurance program. Most of the pastors that I have worked with over the years who have opted out seemed to have done so for one of these two reasons: (1) They do not believe that the social security system will survive to pay the benefits that have been promised and/or (2) They do not want to pay the self-employment tax (especially on their housing allowance) and they believe that they can save/invest the amount that would have been paid as taxes to the IRS and come out ahead over the long term by so doing. I will also add a third argument which I hear from time to time which is a combination of “I just don’t plan to ever retire and that God will provide for me”. I will have to admit that as a young CPA I was firmly in the “opt out” camp and I agreed fully with both of these arguments. If CPA’s could have opted out of social security I probably would have done the same thing at that point in time! However, over the years I have changed my opinion to a now strongly held belief that opting out of social security is dangerous. I will do my best to explain my reasoning for this and offer solutions to those who have already opted out of social security. Let’s look at the two primary arguments for opting out as both have merit and should be carefully considered:

Argument #1 – The social security system will not survive to pay benefits for me:
Based on what we are seeing from the federal government at the present time, this argument is tough to refute. Hardly a month goes by without some ominous article or warning about the social security system with projections that benefits will begin to be paid out to retirees that are in excess of the tax that is collected from current workers. These warnings are even printed on the benefits statements that are issued by the Social Security Administration. I am certainly concerned about the solvency of the social security system (and our government as a whole, I might add!). However, if you use this argument to justify opting out of social security, you have to seriously consider the importance of the social security system to the American economy. Practically speaking, it is almost impossible to imagine a scenario where the system would completely disappear or stop paying benefits to those who have qualified for them. The system is simply too important for this to occur. There is a reason why the social security system has been historically called the “third rail” of government – proposing modification to the social security has been lethal to many a politician’s career over the years. While the retirement age to qualify for social security benefits may be increased and payroll taxes will almost certainly be increased at some point, I do not believe that the system itself could ever disappear or completely disavow its promise to pay benefits to younger workers. I may be wrong, but I simply cannot imagine this scenario ever coming to pass.

Argument #2 – I will opt out and save/invest the additional taxes that I would have paid to the IRS:
This is the weaker of the two primary arguments in my view and is very easy to refute based on what I see every day in our CPA firm. While the theory for this argument is good, it simply does not happen in practice for most pastors. I frequently work with pastors who are fifteen to twenty years away from retirement that do not appear to have saved any significant amount of money and have opted out of social security. In some cases, these pastors also do not have disability insurance coverage or adequate life insurance coverage. It is so easy to set a lifestyle based on a set amount of money and forget that some of the money that is funding this lifestyle was intended to fund retirement. So, what tends to happen year after year is that “life” gets in the way of intended retirement plans – braces for the kids, college tuition, weddings, home improvements, etc. – all have a way of crowding out retirement savings.

Argument #3 – I don’t plan to ever retire and God will provide for me anyway:
I think it is very admirable to plan to work as long as possible, especially when you find your work emotionally fulfilling. However, sometimes this option simply isn’t available to you as the aging process can bring any number of physical challenges or even disabilities of some sort. Additionally, I certainly do agree that God provides for his children but I believe that one of the ways that he provides for his children in our modern society is through insurance! To just simply say that God provides and ignore disability, life or health insurance options that are available seems to me to be putting God to the test to some degree.

In this first of two articles, I have attempted to alert pastors to this critical issue and some of the arguments that are used when deciding to opt out of social security. My bias against opting out of social security has certainly come through, and in the next article I will do my best to explain the full extent of benefits that are offered under the social security system. I will also lay out a full action plan for pastors who have already opted out of social security so that they can make sure that they have adequately planned for their future retirement.

 

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