Even in a difficult economic environment, employers need to attract and retain top talent. One way to do this is by offering high-level executives a non-qualified deferred bonus plan, also known as a supplemental executive retirement plan (SERP).
Unlike qualified retirement plans, non-qualified SERPs allow your company to provide benefits to your key employees on a selective basis. You decide who participates, what benefits will be provided, and how and when benefits will become vested.
Most importantly, key employees find SERPs attractive because they permit higher retirement savings. Nondiscrimination rules that apply to qualified plans, such as 401(k)s, allow them to contribute only a certain amount above and beyond what other employees choose to set aside—typically 125 percent of rank-and-file employees’ contributions, or two percentage points higher, whichever amount is larger. Even if your talented $300,000-a-year execs want to contribute 10 percent or more of salary, their contributions might be capped at five percent because other employees save an average of only three percent. A SERP allows you to work around this reverse discrimination and reward talented top executives.
SERP benefits for employers:
- Recruit, retain and reward key employees
- Selectively single out plan participants
- Determine individual benefit levels
- Continue existing retirement plans without change
- Minimize filing and reporting requirements.
SERP benefits for employees:
- Increase retirement savings with no change in current compensation
- Obtain survivor benefits during employment and/or retirement, depending on plan design
- Can receive additional or accelerated benefits upon a change in corporate control or ownership.
A SERP is considered a “top hat” plan and therefore exempt from many ERISA requirements. A plan qualifies as a top hat plan if it is created for the purpose of providing benefits to a select group of top management or highly compensated employees.
Setting up a SERP
SERPs are relatively easy and inexpensive to set up and administer. Your company and the key employee enter into an agreement that says you will pay the employee a certain amount of money, either over a period of time or in a lump sum upon death, retirement or termination of the plan. You must notify the Department of Labor in writing within 120 days of the adoption of the plan. When the SERP benefit comes due, the executive receives taxable ordinary income and your company receives a tax deduction. You Can Finance the SERP in a Number of Ways:
- Company cash flow. While this may be the easiest method, the company must earmark future cash flow or assets to make payments over potentially long periods of time.
- Accumulation fund. Create an investment fund out of which benefits will be paid. However, the fund will be subject to market risks and gains may taxable.
- Company-owned life insurance. The company buys life insurance on the executive; the plan can draw benefit payments from either the death benefit or internal growth of cash values. This method offers a number of income tax advantages: cash values grow income tax-free; death benefits are generally paid income tax-free; and cash values may be sufficient to recover the costs of funding the plan. As a result, it can cost significantly less to finance a plan with life insurance.
One caveat to consider: While they come with less red tape than stock or qualified plans, you most likely will want a specialist to administer it (usually the same firm that set it up). That’s because executive benefit plans are covered by section 409(a) of the tax code, meaning that they require an experienced adviser who can avoid potential penalties or unexpected taxation. For more information, please contact us.
Section 162: Fast and Easy
One popular type of SERP is a Section 162 life insurance plan. Under this agreement, the employee purchases a cash-rich insurance policy and names himself as owner. This policy may be issued on a single insured basis or a joint insured basis, such as a husband and wife together. The employee controls the policy, including naming the beneficiary and the cash value.
The company pays the premiums, which are fully tax-deductible as a business expense and considered compensation to the employee. Because the premiums are considered taxable income to the employee, often the employer will ‘double bonus’ the employee.
Life insurance’s tax advantages include tax-free accumulation, tax-free income through loans and withdrawals and tax-free transfer at death.
If the employee is also a stockholder of the company and his/her tax bracket is less than the corporate tax bracket, the 162 is attractive to the employee-stockholder who wishes to withdraw profits from the corporation.