If your company offers employees a qualified retirement plan, it is probably a 401(k). But this popular option is not the only game in town. You may want to offer an additional retirement savings vehicle — such as a supplementary executive retirement plan (SERP) — to complement the 401(k)s of a select group of employees.
Unlike 401(k)s, SERPs are not qualified plans, so they do not have to meet all of the strict nondiscrimination requirements that often hinder qualified offerings. Of course, there is a tax cost associated with this flexibility. However, SERPs can help your business attract talented executives and keep them on board for a long time.
A SERP is a kind of nonqualified deferred compensation plan that does not have to be offered to the entire rank-and-file. It is commonly used as a perk for officers and other upper-level employees. Typically, details are negotiated as part of an overall compensation package when an executive is hired.
SERPs generally are set up to pay out benefits at a future date — say, upon retirement. They may be provided in a lump sum or a series of installment payments. These payments are subject to tax when they are received, like benefits from other deferred compensation plans.
One variation of a SERP requires the employer to invest in a fund that the employee will subsequently own. This type of account may be funded through the purchase of cash value life insurance on the employee. When the person retires, the employer either transfers ownership of the policy to the employee or uses the policy to pay retirement benefits. Cash value life insurance may also be used to fund other SERP variations.
Because SERPs are not subject to the rules that generally apply to qualified plans, they can provide several financial benefits for executives. For 2021, elective deferrals to a 401(k) plan are limited to $19,500 annually ($26,000 if you are 50 or over). But there is no dollar limit on contributions to SERPs. This can allow eligible employees to accumulate much more in retirement savings.
Similarly, the rules for required minimum distributions (RMDs) do not apply to SERP funds. Currently, 401(k) holders must begin taking RMDs in the year after the year they turn age 72 and in each successive tax year. SERP distributions also are not subject to a penalty tax for withdrawal prior to age 59½.
Distributions from SERPs are taxed at ordinary income rates, but tax is deferred until the employee starts taking withdrawals. SERP holders therefore benefit from the accumulation of funds without any tax erosion. Lump-sum distributions are taxable in full, so employees may want to spread out the tax bite by taking installment payments.
SERPs are not without risks to participants, however. Depending on the structure of the SERP account, the amount employees receive in retirement may be based on their company’s performance. The bottom line: Payments are not guaranteed. If the company goes belly up before SERP withdrawals are made, the funds could go to creditors with superseding claims.
In addition, the SERP may impose certain conditions for the employee to meet to receive a future payout. For instance, an employee may be required to work for the employer for a specified number of years. If this obligation is not fulfilled, the employee ends up with nothing. In other words, unlike with 401(k) plans, participants will not benefit from vesting rules.
What is more, SERPs can result in tax disadvantages. Many higher-level employees expect to be in a lower tax bracket in retirement. But that is not always the case, especially if the employee will be entitled to significant retirement benefits. Remember that SERP withdrawals are taxed at ordinary income tax rates that currently top out at 37% (and could be higher in the future). Plus, the executive may have to contend with high state income tax rates.
Optimal Benefits at a Reasonable Cost
If you decide to offer a SERP, your company may need to make some adjustments. For example, employer contributions to qualified plans are generally immediately tax-deductible. But employers are not entitled to a tax deduction until they pay SERP benefits.
For many employers, extra administration is outweighed by the benefits — notably in attracting and retaining executive talent. Also, you can customize your SERP to provide optimal benefits to select employees at a reasonable cost.
If you would like help determining whether to offer a SERP, our team will help you take the next right step. Contact us today.
© Copyright 2021 Thomson Reuters.
Disclaimer of Liability
Our firm provides the information in this article for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this blog are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.