Guide to Rabbi Trusts: What They Are, Pros and Cons

SmartAsset Team

Sun, Mar 23, 2025, 1:43 PM 4 min read

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A rabbi trust is a type of irrevocable trust that employers use to fund deferred compensation plans for key employees or executives. The money is set aside for the employee but can still be taken by creditors if the employer goes bankrupt. A financial advisor can help you decide if a rabbi trust is a good option for your retirement or compensation plan.

Rabbi trusts got their name from a 1980 private letter ruling issued by the IRS, which involved a trust set up by a synagogue for a rabbi's deferred compensation. The ruling established that assets in the trust would not be immediately taxable to the rabbi, as long as they remained subject to creditors' claims. Since then, rabbi trusts have been widely used in corporate deferred compensation arrangements.

Unlike qualified retirement plans, rabbi trusts are not protected under ERISA, meaning they do not provide the same level of security as traditional retirement accounts like 401(k)s. Instead, these trusts serve as a middle ground - they offer employees some assurance that compensation will be set aside while still remaining part of the employer's assets.

Rabbi trusts are commonly used for executive compensation, severance packages and non-qualified retirement plans, offering a way for companies to set aside funds without triggering immediate tax consequences for employees.

1. Employer establishes the trust.

   • The employer typically creates an irrevocable trust with a trustee who manages the funds.

   • Employer’s contributions cover deferred compensation or executive benefits.

2. Assets are set aside for employees.

   • The trust holds assets, ensuring they are reserved for employee compensation.

   • The employer cannot reclaim the funds for business use.

3. Employees receive deferred payments.

   • Payments begin at a specified date, such as retirement or after a set vesting period.

   • Employees do not have direct access to the trust's funds until payments are distributed.

4. Subject to employer's creditors.

   • Unlike traditional retirement accounts, these assets remain part of the company's balance sheet.

   • If the company goes bankrupt, the trust assets could be used to satisfy creditor claims.

• Tax deferral. Employees do not pay income tax on contributions until they receive distributions. This allows for tax-deferred growth, enabling assets to accumulate wealth over time.

• Employee retention. Rabbi trusts help retain key employees by offering long-term compensation incentives.

• Security. The irrevocable nature of most rabbi trusts protects employee interests by preventing the employer from withdrawing funds or altering the terms once contributions are made.

• Flexible payment. Compensation structures based on specific conditions, such as retirement age, years of service or performance milestones, are available.