Does a ‘rabbi trust’ answer your prayers?

It’s not unusual for business owners and other company bigwigs to agree to deferred compensation (“deferred comp”) arrangements. In short, you earn the money now, and it’s not available until later.

Potential problem: Under the tax rules for deferred comp, you may owe tax on money you haven’t received yet. But there’s an intriguing solution.

Strategy: Set up a “rabbi trust.” As long as you meet certain requirements, the funds transferred to the trust aren’t taxable until you actually get the money in your hands.

Despite a recent tightening of the rules for deferred compensation arrangements, a rabbi trust is still a viable alternative.

Here’s the whole story: If a nonqualified deferred comp plan is “funded” (i.e., the funds are earmarked for the employee and aren’t subject to risk of forfeiture), the dollars set aside for the employee are currently taxable. With an “unfunded plan” where an employee must rely on a mere promise that he or she will receive the benefits, there’s no federal income tax due until the payments are actually received.

The rabbi trust was designed to work around this conundrum. It has nothing to do with religion; the initial trust authorized by the IRS involved the rabbi of a congregation.

For starters, the trust must be irrevocable, so the employer can’t take back the funds or change any of the other terms. Notably, money set aside in the trust must be subject to the claims of creditors. As a result, the funds in the trust aren’t taxable to the employee until they are actually paid out in cash.  

Due to changes enacted in 2004, you can only gain access to the funds in a rabbi trust if a triggering event occurs, such as retirement, death or disability, pursuant to a fixed schedule or due to an unforeseen emergency. Also, no “haircuts” for early withdrawals are allowed. Nevertheless, a rabbi trust may still meet the needs of the company’s top brass. This is especially true if you expect to be in a much lower tax bracket in the future.

Tip: Unlike a qualified deferred comp plan, payments to a rabbi trust aren’t currently deductible by the business. So there’s a tradeoff to consider.