What is a Rabbi Trust?
One of the topics that likely will be tested on the CFP® exam is the rabbi trust. That’s because the rabbi trust involves a number of different topics that the Board can tie together. For example, you have to have a good understanding of trusts, substantial risk of forfeiture, non-qualified plans and life insurance. A rabbi trust is an “informally funded” unfunded trust that is created in connection to an employer’s non-qualified benefit obligations to their employees who are covered under a non-qualified plan. The name rabbi trust emanates from the first trust of this kind being used by a congregation to benefit their rabbi under an IRS ruling.
The IRS ruling indicated that the rabbi would not be taxed on the funds held in the trust until they were distributed to him or his beneficiaries upon his retirement, death, disability or the termination of his employment.
How does it work?
A rabbi trust is typically established as an irrevocable trust meaning that once the trust is established, the employer gives up all rights to the assets and may not terminate the trust. Rabbi trusts are also considered to be grantor trusts meaning that the income from the trust is taxable to the employer and not the beneficiary (the executive in this case). It’s for this reason the employer typically chooses to fund the trust with cash value life insurance, since the growth in the cash value is tax-deferred.
A rabbi trust is used as a funding vehicle for a non-qualified retirement plan which is a plan that is sometimes offered to certain groups of employees as a benefit over and above the employer’s qualified retirement plan such as a 401(k). Non-qualified plans fall outside the rules of ERISA that govern plans such as a 401(k).
As a funding mechanism for a non-qualified plan, a rabbi trust offers the covered employees significant protection from a change in the control of the employer via an unfriendly takeover, or from the employer otherwise having a change of heart and attempting to avoid making payments due under the deferred compensation plan. Rabbi trusts are frequently written with a trigger that requires full funding of designated non-qualified benefit programs upon a change of control, as defined within the plan document.
Where a rabbi trust does not provide protection to the covered employees is in the event the employer encounters financial difficulties or if the company becomes insolvent. If the employer becomes insolvent, all trust assets become available to the employer’s creditors, including the non-qualified plan participants. If insolvency or bankruptcy occurs, the plan participants stand in line with the employer’s other creditors.
The IRS has ruled that the establishment of a rabbi trust would not in itself cause a plan to be considered funded for tax purposes, since plan assets are subject to the claims of creditors and are not set aside solely for the benefit of participants. The consequences of a plan being funded for tax purposes are that the plan participants would be immediately taxed on accumulated funds as soon as the participant balances become vested.
What are the advantages of a rabbi trust?
A major advantage of using a rabbi trust to fund a non-qualified benefit plan is that it provides the covered employees with a level of security regarding the funding of their non-qualified benefits. In some types of non-qualified plans, the only security provided to the employees about funding is a mere promise from the employer.
Employers cannot access the assets in the trust if they change their mind about the benefit. If the company is acquired, even in an unfriendly takeover, the assets in the trust will not be impacted. Many rabbi trusts have trigger provisions that provide for the full funding of the non-qualified plan in the event of such a takeover.
How are rabbi trusts taxed?
There are several tax issues connected with rabbi trusts to be aware of:
The trust earnings are currently taxable to the grantor, or employer, rather than to the employee. Employers cannot deduct trust contributions until they are includible in the gross income of the plan participant.
Employees of the company are not taxed on the employer’s contributions to the trust. Additionally, any earnings on the money in the trust are not taxable to the employee. They are subject to taxes on amounts withdrawn from the trust via the non-qualified plan when they retire, leave the company or for other reasons in a similar fashion that withdrawals from a qualified plan like a 401(k) are taxed.
Employer contributions to the rabbi trust are considered deferred wages. These wages are subject to FICA tax. Non-clergy participants should pay FICA tax in the calendar year the contribution is made. Otherwise, FICA tax will have to be paid on the entire distribution (including earnings) when the money is withdrawn.
As you can see, rabbi trusts have many moving parts and could be a source of frustration for exam candidates. If you are struggling with rabbi trust, consider hiring a CFP® exam tutor for help.