An employee researches the pros and cons of a rabbi trust.
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A rabbi trust is a type of irrevocable trust that employers use to fund deferred compensation plans for key employees or executives. The money is set aside for the employee but can still be taken by creditors if the employer goes bankrupt. A financial advisor can help you decide if a rabbi trust is a good option for your retirement or compensation plan.
Rabbi trusts got their name from a 1980 private letter ruling issued by the IRS, which involved a trust set up by a synagogue for a rabbi’s deferred compensation. The ruling established that assets in the trust would not be immediately taxable to the rabbi, as long as they remained subject to creditors’ claims. Since then, rabbi trusts have been widely used in corporate deferred compensation arrangements.
Unlike qualified retirement plans, rabbi trusts are not protected under ERISA, meaning they do not provide the same level of security as traditional retirement accounts like 401(k)s. Instead, these trusts serve as a middle ground – they offer employees some assurance that compensation will be set aside while still remaining part of the employer’s assets.
Rabbi trusts are commonly used for executive compensation, severance packages and non-qualified retirement plans, offering a way for companies to set aside funds without triggering immediate tax consequences for employees.
Employer establishes the trust.
Assets are set aside for employees.
The trust holds assets, ensuring they are reserved for employee compensation.
The employer cannot reclaim the funds for business use.
Employees receive deferred payments.
Payments begin at a specified date, such as retirement or after a set vesting period.
Employees do not have direct access to the trust’s funds until payments are distributed.
Subject to employer’s creditors.
Unlike traditional retirement accounts, these assets remain part of the company’s balance sheet.
If the company goes bankrupt, the trust assets could be used to satisfy creditor claims.
Tax deferral. Employees do not pay income tax on contributions until they receive distributions. This allows for tax-deferred growth, enabling assets to accumulate wealth over time.
Employee retention. Rabbi trusts help retain key employees by offering long-term compensation incentives.
Security. The irrevocable nature of most rabbi trusts protects employee interests by preventing the employer from withdrawing funds or altering the terms once contributions are made.
Flexible payment. Compensation structures based on specific conditions, such as retirement age, years of service or performance milestones, are available.
Despite their advantages, rabbi trusts also come with certain risks and limitations. One major drawback is the lack of protection from creditors. If the employer faces financial difficulties, trust assets may be used to satisfy creditor claims.
Another concern is employer control over funding. The employer determines how much and when contributions are made, meaning there are no guaranteed ongoing deposits into the trust. This lack of funding security can create uncertainty for employees relying on deferred compensation. When employees eventually receive distributions, they are taxed as ordinary income rather than benefiting from the lower capital gains tax rates, potentially leading to a higher tax burden.
While rabbi trusts are primarily used for deferred compensation plans, they also serve other financial and estate planning purposes, such as:
Severance agreements. Employers can use rabbi trusts to pre-fund severance payments, ensuring employees receive payouts even if the company undergoes restructuring.
Golden parachutes. Companies sometimes use rabbi trusts to secure executive severance benefits in the event of a merger, acquisition or leadership change.
Estate planning for high-net-worth individuals. Some individuals use rabbi trust structures to defer compensation as part of a larger tax and estate planning strategy.
An employee reviewing the compensation plan from her company.
A rabbi trust is a non-qualified, irrevocable trust that allows employers to set aside funds for deferred compensation plans while keeping assets accessible to creditors. These trusts provide tax deferral benefits for employees and structured payment plans that encourage long-term retention. However, they also come with risks, particularly in cases of employer bankruptcy, since funds are not protected under ERISA. For executives, employees or employers considering a rabbi trust, consulting with a financial advisor or tax consultant can help determine whether this structure aligns with your long-term financial goals and compensation strategy.
If you want to boost your retirement savings, a financial advisor can work with you to create a plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Mandatory distributions from a tax-deferred retirement account can complicate your post-retirement tax planning. Use SmartAsset’s RMD calculator to see how much your required minimum distributions will be.
