SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (SERP)
Top-level employees may be granted access to a package of benefits known as a supplemental executive retirement plan (SERP) in addition to those provided by the company’s ordinary retirement savings plan.
One type of deferred compensation plan is a SERP. It does not qualify as a plan. That is, neither the employer nor the employee receives a preferential tax treatment similar to that offered by a 401(k) plan.
How SERPs Work
While every employee at a company has value, some are more difficult to replace than others. Companies don’t want to hire executives or other important HCEs who will merely work there until a better offer comes along. They work very hard to attract and retain great talent.
These workers are frequently hired to assist businesses in solving challenging issues. Therefore, a company might include a SERP in the benefits packages for key employees to entice them to stick around for a while. The SERP is a bonus for the employee and offers some protection for the company that wants to retain that employee. SERPs aren’t, however, available to every employee of a company. The companies that sell the plans have different details.
Forms of SERPs
The Standard SERP: In most unfunded accords, the company agrees to fund the retirement plan for its executives or HCEs with its own money. With a defined-benefit SERP, the employer typically determines the benefit amount using a fixed dollar amount or a percentage of the employee’s average final pay. (This kind of plan is the most typical.) Over several years, the company pays that sum. When a person reaches retirement age, payments begin.
The Defined Contribution SERP: A defined contribution plan is an additional type of agreement. When it comes time for some employees to retire, the company places money into an account for them. This works quite similarly to a pension plan. Until the employee retires and receives the payment, the money is invested on their behalf.
The Defined Contribution SERP: When a COO retires at age 65, the company might agree to pay them a benefit that is equivalent to 70% of their average compensation for the previous three years under a defined benefit SERP. Then, over a predetermined period of time—say, 20 years—that money would be paid.
Other SERP Forms: The company may purchase annuities, life insurance, or securities with the money that will be distributed under the SERP. These resources will eventually be given to the staff. 1 To protect the company from paying taxes on investment gains on securities, executives or HCEs frequently obtain life insurance plans.
Requirements for SERPs
In contrast to qualified plans, businesses are not required to provide SERPs to all of their employees. The “top hat” category, which includes CEOs, CFOs, COOs, and other individuals who the IRS deems to be “highly compensated,” is typically the only group to receive SERPs.
In your early years of moving up the corporate ladder, it’s unlikely that you’ll be important to the operation of the company or at a high enough position to be offered a SERP. An HCE, according to the IRS, is someone who earned at least $135,000 the year before if the year in question is 2022 or later, or who owns at least 5% of the company during the current or prior year.
Testing is necessary for a qualified retirement plan to make sure that neither employees nor the company violate contribution caps. However, a non-qualified plan, such as a SERP, is exempt from the fairness test and is not subject to contribution or plan limits.
How are SERPs Taxed?
When monies from an unfunded SERP are received, people must pay income tax on them. Employers may also deduct the rewards at the same time. Due to the fact that the income taxes are postponed, the employee shouldn’t be required to pay any upfront taxes. Due to this design, the account balance can grow without being reduced by taxes.
If the company establishes a funded SERP that sets aside money for employees to serve as a buffer against the firm’s creditors, the money may be counted as current income. Taxes may need to be paid by the employee on those funds.
When money is taken out of SERPs before the age of 59 1/2, there are no penalties. In addition, unlike eligible retirement plans, they do not impose necessary minimum payouts.
Note: For some people, an unfunded SERP is a more tax-advantageous choice because assets in a funded SERP may become immediately taxable to the worker.
Advantages and Disadvantages of SERPs
Financial stability in your later years of work: You can have a high-level position and be considering changing it. A SERP could help you negotiate a higher salary contract at your current company or get what you want with a new employer later in your career.
No caps on contributions: There may be a cap on your qualifying retirement contributions. In 2021, regular employees might contribute up to $19,500 to their 401(k), which they could do up to $20,500 in 2022. However, HCEs are only permitted to contribute up to 1.25 percent, or the lesser of 2 percent or twice the actual deferral percentage of non-HCEs, whichever is lower. 5
Because of this limit, employers occasionally provide SERPs to make it simpler for employees to save for retirement. A standard of living comparable to what was experienced while working may be possible for retirees.
Taxes are paid at a lower rate: You can anticipate paying less in taxes once you retire. When employees retire from their employment, their income often decreases. They are now in a lower tax category than they were when they were employed, which may result in a reduction in their tax obligation on the money they get from a SERP.
SERP funds are subject to the claims of the firm’s creditors, therefore they are not safe against creditors. A SERP is not inherently safe from creditors unless specific planning is done to protect these assets, unlike a 401(k), where the money is protected even if the company ceases to exist. The assets may be safer if you place them in a trust.
Because SERPs are subject to forfeiture, they contain a language describing the circumstances under which the participant will not be entitled to the funds or assets under the plan. SERP funds may not be awarded on the basis of the following: leaving the company before the funds have vested; failing to accomplish work objectives; or being fired for good reason.
The SERP "Swap"
To counteract the tax burden brought on by excessive SERP benefits and increase the amount of property passing to the Executive’s beneficiaries, Executives and employers have access to a relatively new planning strategy. This method entails “swapping” advantages from the SERP now or in the future for benefits from a split-dollar life insurance contract (“SERP Swap”). In order to implement the SERP Swap, either the Executive’s current SERP account balance must be decreased (reducing the employer’s obligation to provide retirement benefits to the Executive in the future) or future SERP account credits must be reduced or eliminated, with the money then being used to pay the premiums for an equity split-dollar life insurance policy. The executive’s life insurance premiums would be designed to roughly reflect the present value of the sums that would have been due to the Executive in the future under the SERP plan. The trustees of an irrevocable life insurance trust (ILIT) that the Executive would create would own the policy, which would be issued on his or her life. The insurance policy would designate the trustee of the ILIT as the beneficiary. By using this method, the Executive can convert the planned retirement benefits, which would otherwise be subject to income and estate taxes as previously stated, into a death benefit that will transfer to the Executive’s ILIT beneficiaries free of both income and estate taxes.
An amount equal to the one-year term cost of declining life insurance, or the “economic benefit” of the arrangement, or a portion of the premiums paid by the employer under the split-dollar agreement, would be classified as income to the Executive. The remaining portion would be equivalent to an interest-free loan from the employer to the trustee of the Executive’s ILIT, which would be repaid upon the Executive’s termination or death, or upon surrender of the policy. The policy would be collaterally assigned to the employer by the trustee of the Executive’s ILIT in order to secure the employer’s claim against the policy for recovery of premiums paid by the employer. The Executive would therefore be considered to have given the ILIT a gift in the amount of the “economic gain.”
In the event that the ILIT is properly set up, the death benefits would, following the death of the Executive, pass from the insurance contract to the trustee for distribution in accordance with the ILIT’s conditions and would not be regarded as part of the Executive’s estate. Additionally, neither the trust nor the beneficiaries of the money received by the trustee would be taxed on it.
For people who have accrued, or anticipate accruing, excessive retirement benefits under a SERP plan, the SERP Swap methodology is a potent tax-savings method. The SERP Swap technique is a great way to maximize tax savings and wealth transfer while not compromising an individual’s retirement needs, provided that an individual’s retirement needs are balanced with his or her goal of minimizing income and estate taxes as well as his or her goal of passing property to beneficiaries.
Tax Considerations of SERPs
The SERP Swap approach has a number of potential income tax obligation difficulties that should be taken into account in each circumstance before using the technique.
Constructive receipt of income: The Internal Revenue Service (IRS) argued in Martin v. Commissioner, 96 T.C. 814 (1991), that when benefits from one deferred compensation plan were exchanged for benefits from another deferred compensation plan, a plan participant was in constructive receipt of income. However, the Tax Court determined in Martin that, given the facts and circumstances of that case, the exchange of plan benefits did not result in the plan participant’s constructive receipt of income.
Assignment of Income: The IRS may also contend that the Executive assigned income in connection with the swap between the two distinct plans. The benefits should be regarded as being exposed to a significant risk of forfeiture, nonetheless, if the Executive’s benefits under the SERP plan are unfunded and his or her claim to the benefits is no larger than that of an unsecured general creditor of the business. Therefore, there shouldn’t be any income for the Executive to assign.
IRC Section 83: Lastly, the IRS may contend that because the plan member is receiving property in return for services, the exchange of benefits under one deferred compensation plan for benefits under another triggers taxable income to the Executive under IRC Section 83. There is a counterargument that states that at the time of the plan benefit exchange, the Executive does not get any property under either plan and does not have a right to receive any property under either plan.
All three of the aforementioned factors should be taken into account while considering a prospective SERP Swap scenario, taking into account specific facts and circumstances.
Before using the SERP Swap approach, there is another potential drawback related to estate taxes that needs to be taken into account. The Executive may not retain any episodes of ownership, as defined in Treasury Regulation Section 20.2042-1(c)(2), in the ILIT or over the life insurance policy held in the ILIT, to prevent the proceeds of the life insurance from being includible in the Executive’s estate. As a result, the Executive is no longer permitted to borrow money against the life insurance policy or withdraw financial benefits from it. As a result, the Executive waives all claims to the policy and its proceeds, and as a result, the Executive will no longer be able to use the insurance for any purpose, including paying for retirement. Additionally, to the extent that the employer does not receive the proceeds of the life insurance contract, any events of ownership held by the employer will be assigned to the Executive if they are the sole or dominant owner of the employer. Section 20.2042-1(c) of the Treasury Regulations (6). Therefore, care must be taken in the design and drafting of the agreement, as with any split-dollar agreement.