Supplemental Executive Retirement Plan: The Ultimate Guide to SERPs

We'll Show You Our 117 Tax Planning Strategies

Save a minimum of $10k in taxes...GUARANTEED!

A supplemental executive retirement plan (“SERP”) is a type of non-qualified deferred compensation plan. It is also often called a golden-handcuff plan or top-hat plan. It is generally offered to a company’s executives or other members of management.  

What is a supplemental executive retirement plan, and how does it work? In this post, we will address those questions and review the eligibility requirements.

What Is a Supplemental Executive Retirement Plan?

A SERP is a type of deferred compensation structure. It is non-qualified, which means that it typically will not allow for initial tax deferral. It is used to supplement other qualified retirement plans.

The “non-qualified” status of a SERP means it falls outside the scope of IRS qualified plans, such as 401(k) plans, cash balance plans, and other defined benefit plans. Also, the “deferred” structure of the plan results from an underlying agreement to provide a certain benefit at a future date. 

There are two types of SERPs: (1) Unfunded; and (2) funded. An unfunded SERP is when the employer contractually promises to pay certain compensation-related benefits at a date in the future. However, that contractual agreement or promise is not secured. A funded SERP is when the company puts the assets in a trust account. An unfunded plan is subject to the company creditors, whereby a funded plan is generally not subject to creditor claims. 

How does a Supplemental Executive Retirement Plan Work?

Employers offer many fringe benefits to all employees equally. However, the company may wish to provide additional benefits to certain employee groups. The goal is usually to increase employee retention for the employee class.

SERPs are typically offered to highly compensated employees (HCEs). As such, an employer may offer a SERP as part of an executive retirement benefits package. 

Because a SERP is a custom plan and not offered to most employees, plan specifics and requirements will vary widely among businesses. But with an unfunded structure, the company will provide the retirement benefit to the specified employees with its cash earned from operations. Some plans are called defined-benefit SERPs. These plans usually will calculate the future benefit as a flat dollar amount or a percent of the employee’s average final pay. There is flexibility in calculating the final contribution based on plan design.

The final retirement benefit is then paid over a certain number of years once the participant reaches retirement age.

Other plans are structured as defined-contribution plans. With this structure, a company will make periodic (often annual) contributions to a specified account until retirement. This will then function much like a pension plan or other retirement structure. 

The company will invest the funds for the employee’s benefit, and then the employee will receive either a lump sum or annuity payment. For example, a defined-benefit SERP could be structured to provide the CEO compensation equal to 80% of his or her average annual. This could be calculated using the last three years’ wages with a 15-year payment term at age 65. 

Many companies will invest the funds in the meantime or simply buy an insurance policy. Life insurance policies are usually the best course of action. This will help shield the company from any funding issues and any tax dues on the investment income.

Let’s look at another example. Assume that XTZ Company enters into a SERP with its CEO, Mary. The SERP will provide Mary with $80,000 a year of income for 15 years starting at age 62. The company then purchases a life insurance policy that designates the company as the owner and beneficiary of the policy. When Mary turns 62 and begins to receive her payments, they will be taxable to her and a tax deduction for the business upon receipt each year. Upon Mary’s death, the company receives the death benefit tax-free. If structured correctly, it can be a win-win.

The reality is that a SERP works like golden handcuffs in that it gives an incentive for the employee to stay at the company to earn the plan benefits.

Supplemental Executive Retirement Plan Rules

Unlike qualified retirement plans, employers are not required to offer SERPs to all company employees. SERPs will typically only be available to personnel in the executive ranks.

self employed

Qualified retirement plans require nondiscrimination testing to ensure that the company offers equitable contributions to all eligible employees, regardless of employee rank. A non-qualified SERP doesn’t require IRS testing and does not have the traditional benefit or contribution limits.

What Are the Tax Issues?

The tax issues are a little more complex. Employees only pay tax on the funds from an unfunded SERP once they are received. This is also the date that the company can take a tax deduction for the payouts. 

Since the taxes are deferred, the employee will not have any upfront tax issues. As a result, the funds will grow tax-deferred. 

However, suppose the employer establishes a funded SERP wherein it sets aside funds for employees to shield them against the employer’s creditors. In that case, the funds could be included in income, and the employee would have to pay tax on the benefit. 

Because SERPs are not qualified retirement plans, there are no early withdrawal penalties if funds are distributed before age 59 1/2. In addition, there is no required minimum distribution. 

Asset contributed in a funded SERP are typically immediately taxable to the employee. For this reason, unfunded SERPs are usually tax-advantageous for company employees.

Is a SERP Worth It?

A SERP can make sense in the following situations:

  • High-income earners. A SERP is often used as part of an executive compensation package. It often can be negotiated upfront with a potential new employer. 
  • Qualified retirement contributions are minimal. Most employees can only contribute to a 401(k) deferral. Because the deferral is rather small for executives, many companies will implement a SERP to provide an additional path for retirement contributions. 
  • Lower tax brackets. Upon retirement age, most executives are in lower tax brackets. This can reduce the tax liability on any SERP distributions.

A SERP might not make a lot of sense in the following situations:

  • No creditor protection. Unlike a qualified retirement plan, SERPs have no creditor protection and can be subject to the claims of creditors. Careful planning needs to be done to make limit creditor claims. This is usually accomplished by contributing funds to a trust.
  • Risk of forfeiture. Forfeiture can occur if the employee has not met the requirements to “earn” or “vest” in the future SERP payout. This usually occurs when the employee leaves the company prior to retirement. This also can happen when leaving the company prior to vesting or not achieving performance thresholds. 

Leave a Comment