Should You Have a Supplemental Retirement Plan

Executives and other key company employees who are hoping to expand their retirement assets beyond their 401(k) or IRA may find the answer in a supplemental retirement plan (SERP). This kind of non-qualified deferred compensation plan is designed to offer additional retirement benefits once you’ve reached the maximum contribution limits allowed by other qualified plans. Understanding their structure and function can help you decide whether a supplemental plan fits with your overall retirement strategy.

Supplemental Retirement Plan Basics

Supplemental executive retirement plans can vary from one employer to the next, but they generally follow the same set of guidelines. The employer determines how the plan will be established; how much it will contribute and what form those contributions will take; and how distributions from the plan are paid out to participating employees. 

When a SERP is set up as a defined-benefit plan, the employee receives either a lump sum or an annuity at retirement, which is equal to a set percentage of the employee’s average lifetime compensation. A defined-contribution SERP would allow for regular contributions to an individual employee account. These funds would be invested on behalf of the employee until the funds are paid out at retirement. Money can also be withdrawn in the event of a disability or by the plan participant’s beneficiary upon the participant’s death. (See: Lump Sum versus Regular Pension Payments.

In terms of how SERPs are funded, life insurance is an option many companies turn to. Your employer takes out a cash-value life insurance policy on you and names itself as the beneficiary. During your lifetime, the employer draws on the cash value to fund your SERP account. When you reach normal retirement age, you can begin making withdrawals. 

How SERP Plans Benefit Employees

There are a few different reasons why you might want to add a supplemental retirement plan to your existing retirement accounts. First and foremost, you’re accumulating funds on a tax-deferred basis and distributions before age 59½ aren’t subject to the 10% early withdrawal penalty. If your employer is using life insurance to fund your account, you don’t have to worry about whether or not enough money is being put into the plan to cover your anticipated future benefit. 

Because the employer assumes responsibility for funding the plan, you’re not obligated to defer any of your salary or bonus money into it each year. The fact that SERPs fall under the heading of non-qualified deferred compensation plans also means that they’re not subject to the same IRS restrictions on annual contribution limits as a 401(k) or another qualified plan would be. Finally, if something were to happen to you, your spouse or other beneficiaries would be able to draw annuity income or a lump-sum survivor benefit so the funds don’t go to waste. (See: Distribution Rules for Inherited Retirement Assets.) 

Taxation of Supplemental Retirement Plans

One thing to weigh carefully before enrolling in a supplemental retirement plan is how it may affect your taxes. Supplemental retirement plans are tax-deferred, meaning you won’t pay taxes on the money until you withdraw the funds in retirement.

The payout you select will affect how you are taxed. Choosing a lump sum would allow you to pay the taxes due all at once, leaving the remaining funds to be included in your retirement income. Opting for regular monthly annuity payments would allow you to spread out the taxation.

If you’re not sure which path is best, run the numbers in both scenarios to see how much you’d be paying in taxes. If your long-term plan includes withdrawals from tax-advantaged accounts, spreading out the payments from a SERP over time may result in more after-tax income.

The Bottom Line

A supplemental retirement plan could significantly add to your savings if you’re planning on sticking with your employer for the long haul. These plans may be most appealing if you’re consistently maxing out your other retirement accounts, but it’s still possible to reap some benefits even if you aren’t. Consider how much more you stand to save and weigh that against the impact of any added tax liability when deciding whether a SERP is right for you.