Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Rabbi Trust

What it is:

A rabbi trust is a type of deferred compensation plan that lets employers transfer money into a trust for executives.

How it works (Example):

Rabbi trusts were first used to compensate rabbis, which is how they get their name. Employees who have money going into a rabbi trust on their behalf are not taxed on those amounts until they actually get a check from the trust. This allows the money inside the plan to grow tax-deferred.

The trust is irrevocable, meaning the employer can't get the money back once it puts it in the trust. However, if the employer goes bankrupt, the company's lenders can raid the trust for money to repay debts outstanding. Rabbi trusts also aren't allowed to pay out to executives if the company's net worth falls below a certain point. The IRS construes doing this as a way to raid the company before declaring bankruptcy and turning everything over to the creditors. The employer cannot deduct contributions to a rabbi trust on its tax return.

Changes in control, such as a merger, generally do not affect the assets in a rabbi trust.

Why it Matters:

The idea behind a rabbi trust is to ensure that the executives will fulfill their future obligations to the company. They can be supplements to a retirement plan and they can offset IRS limits on qualified plans. The IRS has very specific rules on what counts as a rabbi trust.