Understanding Supplemental Executive Retirement Plans (SERPs)

 A Supplemental Executive Retirement Plan (SERP) is a benefit program designed to provide additional retirement income to top-level employees beyond the standard company retirement savings plan. Unlike traditional retirement plans such as a 401(k), a SERP is considered a form of deferred compensation and does not qualify for special tax treatment.

Key Takeaways

• SERPs are non-qualified retirement plans used to attract and retain key executives.

• They do not provide immediate tax advantages for the employer or employee.

• Employers can deduct the benefits as a business expense when they are paid out.

How SERPs Work

Companies offer SERPs selectively to key executives, as these plans do not need to comply with IRS contribution limits applicable to qualified plans. For instance, in 2024, the maximum employee contribution to a 401(k) is $23,000, with an additional $7,500 catch-up contribution allowed for those aged 59½ or older.

A SERP is usually formalized through an agreement between the executive and the company, detailing the supplemental retirement income and eligibility conditions. Funding for SERPs typically comes from the company’s cash flow or a cash-value life insurance policy. Taxes on the funds are deferred until withdrawal, at which point they are subject to standard income tax rates.

Benefits of SERPs

SERPs offer advantages to both companies and executives:

• For Employers:

  • No IRS approval required and minimal reporting obligations.

  • The ability to book an annual expense equal to the present value of future benefits.

  • When benefits are paid, they are tax-deductible as a business expense.

  • If funded through a life insurance policy, the company may recover its costs through tax-deferred growth.

• For Executives:

  • The plan can be customized to meet specific financial needs.

  • Funds grow tax-deferred, with no immediate tax consequences.

  • If linked to a life insurance policy, death benefits can provide financial security to the executive’s beneficiaries, bypassing probate and ensuring continued support for dependents.

Potential Drawbacks of SERPs

While SERPs provide substantial benefits, they come with certain risks:

• No Immediate Tax Deductions: Since SERPs are non-qualified, the employer does not receive an immediate tax break upon funding the plan.

• Creditor Exposure: Unlike qualified retirement plans, SERP assets are not protected from company creditors in the event of bankruptcy.

What Happens to a SERP if You Leave the Company?

If an executive leaves the company, the fate of their SERP depends on the vesting structure outlined in the agreement. There are two main types of vesting:

1. Graded Vesting: Benefits are distributed over time (e.g., 20% per year for five years).

2. Cliff Vesting: Benefits are granted in full after a predetermined period (e.g., four years of service).

If an executive departs before being fully vested, any unvested assets remain with the company.

Funding and Payout of SERPs

• Who Funds a SERP? The employer is responsible for funding the plan, typically through a cash-value life insurance policy.

• How Are SERPs Paid Out?

  • Lump-Sum Payment: Paid all at once, potentially increasing taxable income.

  • Annuity: Distributed periodically over time, which may offer tax advantages.

  • Consulting a financial professional can help determine the best payout option based on an individual’s financial situation.

Final Thoughts

SERPs serve as an important tool for companies seeking to attract and retain top executives. These plans offer flexibility, deferred tax advantages, and potential survivor benefits, but they also come with risks such as vesting conditions and creditor exposure. Executives considering a SERP should carefully evaluate the plan’s terms, particularly the vesting schedule, before making any commitments.

By fully understanding the implications of a SERP, executives can make informed decisions about their long-term financial security.