Should You Have a Supplemental Executive Retirement Plan (SERP)?

They can be a good thing if you have maxed out your IRA and 401(k)

Executives and other key company employees who are hoping to expand their retirement assets beyond their 401(k) or individual retirement account (IRA) may find the answer in a supplemental executive 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 SERP fits with your overall retirement strategy.

Key Takeaways

  • SERPs accumulate money on a tax-deferred basis.
  • SERPs do not have an early withdrawal penalty.
  • SERPs do not have contribution limits.
  • Employers often fund a SERP by taking out a cash value life insurance policy on you.

Supplemental Executive Retirement Plan (SERP) Basics

SERPs 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, 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 Money can also be withdrawn in the event of a disability or by the plan participant’s beneficiary upon the participant’s death.

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 SERPs Benefit Employees

There are a few reasons why you might want to add a SERP 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 nonqualified deferred compensation plans also means they’re not subject to the same Internal Revenue Service (IRS) restrictions on annual contribution limits that 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.

SERPs are usually only made available to company key executives who are already making a substantial salary. They are a means of ensuring that valued employees will remain with the company long term. If you decide you want a SERP, you probably need to make it a part of your negotiating strategy. One thing to remember: SERPs are not protected from a company’s creditors if it is beset by financial woes, so they can go away entirely in a bankruptcy.

SERPs are paid out as either one lump sum or as a series of set payments from an annuity, with different tax implications for each method, so choose carefully.

How SERPs Benefit Companies

SERPs are easy to put together, require little management, and are not subject to approval by the IRS. The company is in charge of deciding whom it wants to favor with a SERP, and it both controls the plan and derives income on its books from the SERP’s cash value growth, which is tax-deferred. A SERP can be set up to allow a company to recover its cost, and the company would get a tax deduction when benefits are paid out.

Taxation of SERPs

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

The payout you select will affect how you are taxed. Choosing a lump sum would require 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 SERP could significantly add to your savings if you’re planning to stick 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're not. 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.

Article Sources
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  1. Fidelity Investments. "Timing Your Deferred Compensation."

  2. Internal Revenue Service. "401(k) contribution limit increases to $19,500 for 2020; catch-up limit rises to $6,500."

  3. Harvard Law School. "The Effect of Executive Compensation on Recoveries."

  4. Internal Revenue Service. "Nonqualified Deferred Compensation Audit Techniques Guide (June 2015)."

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