Rabbi trusts are most often used by companies as a way to attract and retain key executives. The biggest benefit is that high-earning employees don’t have to pay taxes on contributions until they take withdrawals. If you’re an executive who has access to a rabbi trust as part of your benefits package, understanding how it works can help you decide if you should take advantage of it. For example, if your employer has a rabbi trust and you’ve deferred $50,000 of your compensation into that trust, you wouldn’t pay taxes on that $50,000 until you retired or reached another triggering event.
How Does a Rabbi Trust Work?
Think of a rabbi trust as a blanket of security for executives and key employees. Rather than leaving your deferred compensation in a non-qualified deferred compensation (NQDC) plan—where the employer is essentially making a promise to pay you benefits in the future—a rabbi trust helps legally set that promise in stone. As the name implies, the first rabbi trust was set up by a Jewish congregation that wanted to support its rabbi financially after he retired. They got an approved letter ruling from the Internal Revenue Service (IRS) to set up a “rabbi trust” for him, and it’s been called that ever since. The biggest problem with rabbi trusts is that they’re not shielded from creditors. So if your employer becomes insolvent or goes bankrupt, creditors could come after any assets in the rabbi trust. For example, suppose XYZ Company pays Jamie, a top executive, $200,000 a year. It also puts $2,000 a month into a rabbi trust as deferred employee compensation. Jamie is the beneficiary of that money and can start tapping into it once she meets a triggering event outlined in the trust agreement—such as retirement, termination, a five-year work anniversary, and so on. However, if XYZ Company has to file bankruptcy, creditors could dissolve the rabbi trust, leaving Jamie with nothing.
Is a Rabbi Trust Safe?
For the most part, yes. If the company you work for is financially stable but you suspect your employer could refuse to pay benefits, a rabbi trust can help keep your deferred compensation safe. However, if you’re mainly concerned about the company you work for going bankrupt, a rabbi trust can’t save you. In that case, you may be better off with a secular trust, which is protected from bankruptcy.
How Do You Get a Rabbi Trust?
Companies are responsible for setting up a rabbi trust. They’re known as the grantor. The trustee, the one who oversees and manages the assets, may be a bank or trust company that helped set up the trust agreement.
How Much Are Rabbi Trust Taxed?
Your employer is treated as the owner of the trust and is responsible for paying all taxes and reporting all income in the trust. As the employee, you won’t pay taxes on your portion until you start taking distributions. But even then, the trustee is responsible for withholding all appropriate federal, state, and local taxes before you receive your payments. For example, suppose your salary is $150,000 a year, and the company you work for puts an additional $1,500 a month in a rabbi trust for you as a benefit. Come tax time, you’d only pay taxes on your $150,000 salary. The rabbi trust contributions would grow tax-free until retirement.
Pros and Cons of a Rabbi Trust
Pros Explained
Tax advantages for employees: One major benefit of a rabbi trust is that it allows executives to defer income tax on contributions until they withdraw the money from the trust in retirement.Protects employees from change of heart or change of ownership situations: Unlike stand-alone NQDC plans, which are essentially a promise from an employer to pay out future benefits, rabbi trusts are typically irrevocable and will always be paid out to the employee unless insolvency occurs.
Cons Explained
Creditors can come after assets: If the company goes bankrupt, the money in a rabbi trust may not be protected from creditors.No tax advantages for employers: Unlike other types of trusts, rabbi trusts provide no tax benefits for employers.
Rabbi Trust vs. Secular Trust
One important difference is that creditors can’t come after any assets in a secular trust if the company goes bankrupt. There’s more protection for the employee. However, secular trusts are taxable as soon as the employee is vested. On the other hand, rabbi trusts aren’t taxable until the employee withdraws from the trust. When the trust does incur taxes, the trustee must handle those taxes. The downside with rabbi trusts is that they aren’t protected from creditors.
