What is a Rabbi Trust?

In the United States, the rabbi trust is a non-qualified, deferred compensation arrangement created by employers for their employees. The first Internal Revenue Service Letter ruling approved the use of this type of trust involved a Rabbi; thus, it is called the Rabbi Trust. 

The amount contributed buy the employer into the rabbi trust is not considered to be a part of the employees wage and is tax-deferred. This means the employee does not not have to pay any tax for that amount until she actually receives the money from the trust. 

For example, an employee gets $60,000 per year as a salary. The employer contributes $500 to the employees rabbi trust each month. The employees taxable income is $60,000 a year. 

The additional $6,000 is not considered to be a taxable income until the employee withdraws the money or gets an actual check from the trust. This allows the assets of the employee to grow tax-deferred inside the trust. 

The trust is irrevocable and outside the control of the employers. Once an employer contributes to a rabbi trust, he or she is not allowed to get the money back.

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How does a Rabbi Trust Work? 

The Rabbi trust does not provide any tax deduction to the employer until the year in which the employee receives the benefits from the trust. At that time, the employer can take a deduction against taxable income for the amount of the distribution of trust funds to the employee. That makes its use limited in comparison to other types of trusts. Most commonly, a rabbi trust is used by an employer to provide a source of funds to satisfy the employer's obligation to executives under a non-qualified benefit plan. Under the federal and state law, the general creditors of a company may claim the assets held by the rabbi trust on the occasion of insolvency. The law allows the creditors of a company to have access to the trusts assets if the employer goes bankrupt or the company becomes insolvent. Mergers or takeovers do not generally affect the assets of the trust. After a trust is set up, only the beneficiaries (or the trustee) have the power to change its details. An employer cannot change the structure and terms of the trust once it is created. The company that takes over does not have the power to change the terms of the trust. Employers are not allowed to take out funds from the trust at any conditions. Thus, the funds held by a rabbi trust is protected and are dedicated to the serve the interests of the employee. Unless the company faces an insolvency, the funds are safe in the trust.