What Is a Secular Trust for Deferred Compensation?

A secular trust is a non-qualified deferred compensation arrangement. It funds future employee benefits, securing promised payments and ensuring funds are available regardless of the employer’s financial stability.

Defining a Secular Trust

A secular trust is an irrevocable trust established by an employer to hold funds for an employee’s future benefit. Once contributions are made, the employer cannot reclaim them, and assets are immediately vested in the employee. This means the employee has a nonforfeitable right to contributions and any earnings generated within the trust. Funds in a secular trust are protected from the employer’s creditors, offering security for the employee’s deferred compensation.

The trust is established with a third-party trustee who manages the assets. For tax purposes, the employee is treated as the owner of the trust. This structure ensures the employee has a direct claim to the funds, enhancing security. The trust’s irrevocability means it cannot be altered or terminated by the employer, safeguarding the employee’s interest.

Contributions to a secular trust are made to fund nonqualified deferred compensation plans. The assets held within these trusts are conservative investments. This ensures the stability and availability of funds when distributions are due.

Taxation of Secular Trusts

Contributions made by an employer to a secular trust are immediately taxable to the employee as ordinary income. This taxation occurs in the year contributions are made and become vested, even if the employee has not yet received the cash. This immediate tax liability is a direct consequence of the funds being secured and beyond the employer’s creditors.

Earnings generated within the secular trust are taxable to the employee each year as they accrue. The employee is responsible for paying taxes on the growth of trust assets annually. Employers sometimes “gross up” contributions or provide a cash bonus to help cover this immediate tax burden.

From the employer’s perspective, contributions made to a secular trust are tax-deductible in the year they are included in the employee’s gross income. This provides the employer with an immediate tax deduction. The employer does not receive a deduction for earnings on contributions once they are in the trust.

Secular Trusts Versus Other Deferred Compensation Plans

Secular trusts offer a different approach to deferred compensation, particularly when compared to rabbi trusts. The difference lies in the security of funds and their vulnerability to an employer’s financial distress. In a secular trust, assets are held in an irrevocable trust for the employee’s exclusive benefit and are protected from the employer’s creditors.

Conversely, a rabbi trust, while also used for non-qualified deferred compensation, keeps funds subject to the claims of the employer’s general creditors. In the event of the employer’s bankruptcy, assets in a rabbi trust could be used to satisfy debts, potentially leaving the employee without promised deferred compensation. This makes the rabbi trust a less secure option from the employee’s viewpoint.

The trade-off for enhanced security of a secular trust is the immediate taxation of contributions and earnings to the employee. With a rabbi trust, employees defer taxation until funds are actually distributed. A secular trust prioritizes security, making the employee responsible for current taxes. A rabbi trust prioritizes tax deferral but carries the risk that funds may be lost if the employer’s financial health deteriorates.