A supplemental executive retirement plan (SERP) is a non-qualified employer-provided benefit typically offered to high-level employees. How, when, and what options are available to you regarding receiving that potentially substantial amount has repercussions for retirement, taxes, and the ability to use it for various financial planning goals. The SERP can accumulate significant income, making it a valuable tool for building your nest egg.
Not to be confused with a Nonqualified Deferred Compensation Plan (NQDC), when the employee defers their own compensation, the employer designates contributions to the executive in a SERP plan. Although many employers often will offer a combination of non-qualified deferred comp and SERP plans simultaneously. To learn the ins and outs of an NQDC, check out our blog post 7 questions to consider before you participate in a deferred compensation plan.
Who is eligible for a SERP?
A company is free to offer the SERP to as many employees as it likes. However, it is mainly used in two instances.
- To attract and retain executives who’re already maxing out their contributions to a company’s qualified retirement plans.
- To help an executive who is designated a highly compensated employee (HCE). HCEs are subject to IRS restrictions on participating in a 401k. A SERP is used to help ease the pain of those restrictions, providing the HCE with some additional retirement support. You can learn more about HCEs in our blog on how to overcome being designated an HCE.
How does a SERP work?
The SERP differs from regular retirement plans. First of all, it’s a non-qualified plan. Unlike a 401(k), it doesn’t have a contribution limit or rules requiring it to be open to all employees. The funds can be withdrawn, without penalty, before you turn 59½, nor do you need to begin required minimum distributions at age 72. Although most employers require distributions to begin at retirement or when you are no longer employed.
SERPs can be designed with many different options or configurations. At its root, the employer agrees to pay a certain sum to the employee in the future. Typically, during the annual open enrollment period, the executive can choose when and how to receive the following year’s benefit – before retirement, after retirement, in a lump sum, or in a series of payments. It all depending on the SERPs flexibility, which is up to the employer.
Employer contributions to a SERP are included in the executive’s income for purposes of FICA and FUTA taxes in the year they become vested. Income taxes, however, are deferred until you begin receiving distributions. SERP withdrawals are taxed as W-2 income in the year received. If you receive your payout in a lump sum, you’ll pay the taxes at all once. If the payments are spread out over multiple years, so are the income taxes.
What happens to the Funds?
Like the different payment options, employer contributions to the SERP have various possibilities.
- Life Insurance
- Company stock bonds
- Investment options
Typically for only the top few executives, there are instances when corporations purchase a life insurance policy on the executives’ lives. When they retire, the company would either transfer the policy’s ownership to the employee or use its cash value to pay the employee their benefit at retirement.
The much more common scenario is that the funds are vested in the employer’s stock, bonds, or simply invested in an interest-bearing account. Once vested, the employer often allows you to select from a menu of investment options, like a 401k, where the funds grow tax-free until you take distributions.
How to take advantage of a SERP
Remember, there are no limits to SERP contributions. This benefit could grow into millions of dollars. Here are just a few of the situations when a SERP is helpful.
If you’re a high earner and are already maxing out your 401k, a SERP can really supercharge your retirement savings. It may even allow you to retire early, providing some much-needed cash flow for retiree health insurance until Medicare.
A SERP may also provide funding for pre-retirement purposes. If your employer allows in-service distributions, you could use them for college tuition, a vacation home, or any other non-retirement goal.
Many SERP plans have some flexibility to mix and match distributions. Save some for retirement, plan others for college tuition. If your plan has liberal distribution options, you can plan them out in advance so it can provide some extra cash flow when it’s needed the most.
A SERP can be negotiated. Top-level key executives can arrange a specific plan just for themselves. It can be used to create the famous “golden parachute.” A SERP is a common benefit for CEOs, CFOs, and COOs to protect themselves if the relationship goes south.
It’s not all butterflies, kittens, and rainbows with a SERP. There is a dark side with several significant risks.
- If the SERP funds are invested in the company stock or bonds, they may not perform well. Reducing your future payout.
- Even worse than poor performance, if your company files for bankruptcy, you will lose the SERP. A SERP is only a promise to pay in the future. Bankruptcy could void that promise.
- Vesting: Don’t think you’ll be able to work for a year or two and take your money and run. There will be vesting requirements that you remain employed for a specific number of years before you are eligible to receive your benefit.
- High tax potential: The potential of a significant SERP value is a double edge sword. All of those funds have to be paid out eventually.
You have to balance these risks versus the reward of participating in a SERP. This is where financial planning comes into play. You have to design a tax-efficient strategy to receive your SERP funds and work it into your overall financial plan.
SERPs are a valuable employer benefit. It can ramp up your retirement or provide for other financial goals. However, understanding the terms, risks and incorporating the SERP into your overall financial plan will serve you well.
Do you have a SERP Plan that you’re unsure about or don’t have a full grasp of? Contact us to make sure it’s incorporated into your overall financial plan and tax strategy.