Life Insurance

Insurance for Businesses Series: Supplemental Executive Retirement Plan (SERP) Non-qualified Deferred Compensation

Peachie Thompson · January 18, 2022

Successful business owners need ways to protect their companies, compete for top talent, reward employees and plan for a financially secure future. An excellent financial planner understands these needs and know the various roles insurance play in these situations. This is the fifth one of a 5-part series dedicated to businesses and the role of life insurance in solving some of the concerns of business owners.

If your client is a business owner and the financial plans you have made with them hinges on business income or if a big part of their net worth is in the business. It is critical that you bring this often-overlooked problems to your client's attention.

At one point in my career, I had the privilege of working for a company that specializes in placing large sums of life insurance on Fortune 100 companies' executives as well as doing the administration for such plans. It was then that I learned that, in addition to the usual qualified plans, there are plans that highly paid employees can take advantage of to help fund an awesome retirement.

I learned of such attractive compensation tool designed to help business owners retain top executives or certain owners by helping to supplement their retirement income. Here, I will share with you some of what I learned.

We all know that traditional retirement plans have contribution limits. If high income earners solely relied on qualified plans, there's a possibility that they could face a retirement income gap. A Supplemental Executive Retirement Plan (SERP) is an employer-paid deferred compensation agreement that provides supplemental retirement income to key executives, based on the employee meeting certain conditions.

Basically, it is an arrangement between an employer and selected key executives in which an employer promises to pay a specified benefit to the employee at retirement. If death occurs prior to retirement, a survivor benefit may be paid to the employee’s beneficiary. A SERP is considered a non-deferred compensation arrangement even though the employee does not defer compensation. It is essentially a fringe benefit on top of the employee's regular compensation from the employer.

Why would a business do this for a key executive?

  1. First, it is an impressive recruitment and retention tool.
  2. Then, if funded with life insurance, a business obtains a tax-advantaged asset to pay the promised benefits.
  3. For the business, it is a tax-deductible benefit payment (there are no immediate tax-deduction for the business, benefits are generally tax-deductible to the business when they are paid to the employee).
  4. It is simpler than traditional qualified plan even though it also requires plan documents and administration.
  5. If the key executive dies, there's a potential to recover plan costs with income tax-free death benefit proceeds

What are the ways to fund a SERP?

  1. A business could choose to leave the plan unfunded. In this scenario, the business would pay the promised benefit out of cash flow. There are no funds set aside by the employer in this case.
  2. Or, a business could use equities/mutual funds. In this scenario, the business is taxed on investment earnings. Another item to consider if doing this, is that the assets must remain available to the business' general creditors.
  3. A business could informally fund using life insurance. In this scenario, cash values are taxed deferred. Cash values accessed using policy withdrawals or loans could help pay benefits owed. Life insurance death benefit can match the death benefit obligation from day one and it could also be used to recover plan costs.

Why would a key executive like this? It gives them the potential to have survivor benefits for their loved ones. It is also a tax-deferred benefit to them as a reward for all their hard work for the business.

How does it work when funded with life insurance?

  • A SERP agreement is executed between selected key executives and the business.
  • The business purchases a life insurance policy on the life of a key executive. A notice is given to the employee that the policy is being applied for. The employee must give their written consent for the life insurance to be purchased.
  • The business is the owner, payor and beneficiary of the life insurance policy.
  • The business pays the promised benefit upon the key executive's retirement. This payment is generally tax deductible to the employer.
  • The key executive pays income taxes due on the benefit received.
  • If the key employee dies before retirement, the business receives the death benefits, generally income tax-free assuming compliance with section 101j . It may use the proceeds to pay the promised taxable survivorship benefits to the employee’s family, creating a tax deduction for the business.
  • The employee’s heirs pay income taxes due on the survivor benefits received.

This type of plan is limited to a select group of highly compensated employees. The business can selectively determine eligibility requirements and benefit levels. It is worth mentioning that plan assets are subject to the claims of the employer's creditors.

Again, I am not a lawyer or an accountant. I'm simply here to educate you about insurance. That said, you should know that for federal income tax purposes, life insurance death benefits generally pay income tax-free to beneficiaries pursuant to IRC Sec. 101(a)(1).

In certain situations, however, life insurance death benefits may be partially or wholly taxable. Situations include, but are not limited to: the transfer of a life insurance policy for valuable consideration unless the transfer qualifies for an exception under IRC Sec. 101(a)(2) (the transfer-for-value rule), arrangements that lack an insurable interest based on state law, and an employer-owned policy unless the policy qualifies for an exception under IRC Sec. 101(j). It is also worth mentioning that annual increase in policy cash values and death benefit proceeds may have corporate alternative minimum tax implications.

If you are a fee-only planner, advisor or a client and would like to know more about this topic, please email me at peachie@peachinsurance.net or share this with your friends using the social media links below.

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