Can't get enough of a good thing? To hoard even more money for retirement than the tax law allows for qualified plans (such as 401(k)s or pension plans), arrange things so your company makes contributions on your behalf to a nonqualified deferred compensation plan.
In such cases, you face one potential pitfall: If you're guaranteed to receive payment, those dollars are taxable right away, even if you won't get your hands on the cash for years to come.
Strategy: Put your faith in a "rabbi trust." Using a rabbi trust, you don't need to pay any current tax because the money is technically available to other creditors. Still, the cash is socked away in a separate account, so it won't be used for general spending.
For decades, the rabbi trust has been an airtight way to maneuver around the tax requirements for deferred comp plans. But a tax law enacted last year throws a monkey wrench into that strategy. Fortunately, you can still preserve your retirement tax shelter with a few minor tweaks in your trust document.
Deferred comp plans are treated as being either "funded" or "unfunded." If the plan is funded, the money is earmarked to you for future payment or the assets are available to you without restriction. With funded plans, you must pay current tax on the contributions even though you won't get any cash until later. Not a good thing.
On the other hand, if the plan is unfunded, your company merely promises to make payments to you at a later date. You don't need to pay any current tax, but you can't be totally sure you'll ever get the money.
That's where the rabbi trust comes to the rescue.
Named for the IRS ruling that created this strategy—a rabbi being paid deferred money—the deferred compensation is deposited into a separate trust account. The money is available to company creditors as well as you. As long as you don't have a greater right to the money than other creditors, income taxes are postponed until you actually receive the payment.
Thus, you have a "vested right" to the future payment, whether or not you ever perform any more services for the company. In the meantime, your company pays tax on the current earnings of the trust assets. (While income taxes are deferred, Social Security and Medicare taxes are due as soon as benefits become vested.)
New law crackdown: Last year's tax law imposed new restrictions on deferred comp plans. Failure to comply with the rules, effective for amounts deferred after 2004, can result in triggering current income taxes, plus hefty penalties.
Specifically, the new law prohibits companies experiencing financial difficulties from using a "springing rabbi trust." It removes assets from a creditor's reach upon a specified financial trigger. If the plan includes such a triggering mechanism, any deferred amounts are immediately taxable under the new law.
Tip: If you hold a rabbi trust, modify the terms, if necessary, to eliminate any "springing" provisions.
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