SERPs: Pros and Cons for Employers and Executives

August 4, 2021

If your company offers employees a qualified retirement plan, it’s probably a 401(k). But this popular option isn’t 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 aren’t qualified plans, so they don’t have to meet all of the strict nondiscrimination requirements that often hinder qualified offerings. Of course, there’s a tax cost associated with this flexibility. But SERPs can help your business attract talented executives and keep them on board for a long time. Let’s take a closer look.

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A SERP is a kind of nonqualified deferred compensation plan that doesn’t have to be offered to the entire rank-and-file. It’s 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’re 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.

Key Advantages

Because SERPs aren’t 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’re 50 or over). But there’s 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) don’t 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 aren’t 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.

Potential Risks

SRPs aren’t 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 aren’t 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 isn’t fulfilled, the employee ends up with nothing. In other words, unlike with 401(k) plans, participants won’t benefit from vesting rules.

What’s more, SERPs can result in tax disadvantages. Many higher-level employees expect to be in a lower tax bracket in retirement. But that’s 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 aren’t 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. Contact us for more information.

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