Finding religion with a rabbi trust

With the significant drawdown of many employee retirement plan accounts given the recent stock market decline, now more than ever employers are searching for retirement plan solutions for highly paid employees.

One for an employer seeking ways to benefit only selected key employees may be the adoption of a non-qualified deferred compensation plan. Under a non-qualified deferred compensation plan, an employer promises to pay compensation to employees in the future. This plan differs from qualified plans because the employer does not get a tax deduction until amounts are paid to the employee. The employee is subject to income tax at the time of distribution (or when first made available to the employee, if sooner). One such vehicle that can hold deferred compensation assets is the “rabbi trust.”

A rabbi trust is a security device for a deferred compensation plan for which an employer sets aside and contributes amounts to an irrevocable trust on behalf of one or more employees. There also is a deferred compensation agreement between the employer and employee establishing the amount and conditions of deferral.

They can:

• Offset IRS limits on qualified plans (as an excess benefit plan, 401(k), etc.)

• Provide a voluntary deferred copensation plan

• Supplement an executive’s retirement plan

The terms of the trust agreement outline the responsibilities of the parties, such as investment decisions, payout procedures, duties of the trustee and other applicable provisions. The trust represents a binding agreement between the employer and the trustee.

The IRS has approved an arrangement under which key employees who contribute the maximum amount to a 401(k) plan can make excess deductible contributions to an employer’s nonqualified supplemental savings plan funded by a rabbi trust.

Setting up the trust

The trust got its name because the first such arrangement to which the IRS gave an official “blessing” was set up for a rabbi by his congregation. However, the trust can be established by any type of organization — religious or secular.

A rabbi trust is designed to secure the employer’s agreement to pay the deferred compensation in the event of management changes, compensation adjustments and other corporate decisions.

It assures that the assets will eventually be distributed to the employee. However, should the employer become insolvent, the trust’s assets would become subject to the claims of the employer’s general creditors.

The IRS has published a model trust agreement that companies can use for their rabbi trust arrangements.

Employers should meet with their own legal and tax advisers to confirm that the model agreement meets their needs and to choose among many alternative and optional provisions offered by the IRS.

Donald E. Sommese, a certified financial planner, works in the Nashua office of Morgan Stanley. He can be reached at 603-881-3300.