A SERP may sound like a creature from a science fiction movie, but it is actually a popular retirement savings vehicle for the top brass. Typically, the SERP—an acronym for Supplemental Executive Retirement Plan—is used to complement a 401(k) or other qualified plan. It offers generous benefits to a chosen few and enables an employer to attract and retain “the best and brightest” employees.
Background: Generally, a qualified retirement plan like a 401(k) must meet strict nondiscrimination requirements and adhere to various other rules. For 2021, an employee can defer up to $19,500 of wages to a 401(k) on a pre-tax basis, plus another $6,500 if he or she is age 50 or older. To sweeten the pot, the employer may provide a SERP.
This is a kind of nonqualified deferred compensation plan that does not have to be offered to all employees. Instead, it can be set up to benefit only several people or even one person. Thus, it is a valuable perk for certain high-ranking employees. The amounts “allocated” in a SERP cannot be set aside in a separate account for the benefit of the employee (like a qualified plan), but instead must remain part of the employer’s assets, in order to remain not taxable to the employee until paid.
The SERP is designed to pay out benefits at a specified future date, like the employee’s retirement. It may be paid in a lump sum or a series of payments. These benefits are taxable to the employee when received and deductible by the employer at that time. In some cases, the SERP will be funded by a cash value life insurance policy on the employee’s life.
Accordingly, a SERP provides the following advantages.
- Although distributions are taxed at ordinary income rates, the tax is deferred until withdrawals are made. In the meantime, funds continue to accumulate without current tax. In order for the amount in a SERP to remain not-taxable to the employee, there must be a “substantial risk of forfeiture” during the term of the SERP. For example, if the employee is terminated for cause (theft, impropriety, etc.) or violates an agreement with the employer (such as a non-compete agreement), that might be reason for forfeiting the entire balance allocated to that employee.
- The rules for required minimum distributions (RMDs) do not apply to SERPs. Usually, you must begin taking RMDs from a qualified retirement plan in the year after the year in which you turn age 72 (recently increased from age 70½) and in each succeeding tax year.
- Distributions from a SERP are not subject to the usual 10% penalty tax on plan withdrawals made prior to age 59½. This may provide more flexibility for an early retirement.
- The employer can carve out generous benefits for a select few. This may convince a “star” employee to come to or stay with the company. (Each participant has his/her own plan document, and each can have a different contribution rate and a different retirement age.)
On the downside, there are potential risks. For starters, the employee is not entitled to the benefits until the specified date. If he or she leaves earlier, they may get nothing. Also, the SERP may impose certain conditions that must be met to receive the future payout (e.g., working for a set period of years). Similarly, because the payments are not guaranteed, the employee may be left holding the bag if the company goes under and other creditors can claim the funds.
Finally, examine all the tax ramifications. If the employee is in a higher tax bracket in retirement, the tax bite could be substantial. (Plus, rates may rise in the future.) And, from the employer’s perspective, the deduction is not available until the benefits are received.
Bottom line: Both employees and employers should review the details with an employee benefit professional expert and make an informed decision regarding a SERP. It is also important to have an attorney or someone well-versed in §409A and §457 to draft or at least review the SERP documents.