DEFINITION of Rabbi Trust
Rabbi Trust refers to a trust created to support the non-qualified benefit obligations of employers to their employees. A rabbi and his congregation first used this type of trust after an Internal Revenue Service (IRS) private letter ruling approved its use; it has been referred to a rabbi trust since. A rabbi trust is typically used by a company to provide its senior executives with additional benefits to their existing compensation package.
BREAKING DOWN Rabbi Trust
A rabbi trust creates security for employees because the assets within the trust are outside the control of employers; they are typically set up to be irrevocable. In other words, once the employer makes contributions to a rabbi trust, they cannot retrieve them. A significant drawback of rabbi trusts is that they don't protect against creditors. If a company becomes insolvent or goes bankrupt, both the beneficiaries and the company’s creditors have access to the trust’s assets. For example, if a rabbi trust has $500,000 worth of stock and cash in it, both the creditors and beneficiaries would go after those assets.
Rabbi Trust Protection
A rabbi trust protects employees from a company that is experiencing financial hardship and wants to remove some of the trust’s assets to meet its other obligations. For example, an employer cannot withdraw $50,000 from a rabbi trust to pay employee wages. A rabbi trust’s structure cannot be changed by the employer once it has been established, giving further protection to its beneficiaries. For instance, if a company is taken over, the new company does not have the power to change the trust’s terms. Only the beneficiaries of a rabbi trust have the power to change its details.
Rabbi Trust Taxation
A rabbi trust provides tax advantages for employees. Contributions made to the trust do not count as part of the employee’s wages. For example, if an employee receives an annual income of $100,000 and his or her employer makes monthly contributions of $1,000 to the staff member’s rabbi trust, their taxable income is $100,000; they do not have to pay tax on the $12,000 of contribution payments. Rabbi trusts allow employees’ assets to grow without them having to pay tax on any gains until they withdraw their money. In this sense, a rabbi trust is similar to a qualified retirement plan. A rabbi trust does not provide any tax benefits for companies that make its use limited compared to other types of trusts. (To learn more about trust’s, see: Types, Features and Taxation of Trusts.)