What Is the Tax Treatment of SERP Distributions?

A Supplemental Executive Retirement Plan, or SERP, is a form of deferred compensation provided to a select group of high-level employees. As a non-qualified plan, it does not adhere to the same federal regulations that govern retirement vehicles like 401(k)s, and its tax rules differ significantly. The company promises to pay the executive a specified benefit at a future date, often upon retirement, with the funds for this promise paid from the company’s general assets.

Timing of Income Taxation on Distributions

The timing of income tax on SERP distributions is governed by a principle known as constructive receipt. This means the executive is taxed on the income when it is paid or made available to them without substantial limitations. Until that point, the income tax is deferred, allowing the funds within the plan to accumulate without being diminished by annual income taxes.

The plan document dictates when distributions are triggered and, consequently, when the income becomes taxable. Common distribution triggers include separation from service, reaching a specific age, disability, or death. The structure of these payout triggers is regulated to ensure that the executive does not have unfettered access to the funds before the designated time, which would negate the tax-deferral benefit.

The method of distribution also directly impacts the timing of income tax liability. An executive who elects to receive their entire SERP benefit in a single lump-sum payment will pay income tax on the full amount in that one year. If the plan allows for installment payments, the executive will recognize the income and incur the tax liability incrementally as each payment is received, which can be a strategic choice to avoid being pushed into a higher tax bracket.

The funds are treated as ordinary income upon receipt and are subject to federal and state income taxes at the rates applicable in the year of distribution.

Special FICA Tax Rules

A unique aspect of SERP taxation involves the rules for Social Security and Medicare taxes, collectively known as FICA taxes. Unlike income taxes, which are paid when distributions are received, FICA taxes are subject to a “special timing rule.” This rule dictates that FICA taxes are due at the later of two events: when the related services are performed by the executive, or when the SERP benefits are no longer subject to a substantial risk of forfeiture, which means when the benefits have vested.

For many executives, the FICA tax liability on their SERP benefits arises years before they actually receive any cash payments. For example, if a SERP benefit vests after ten years of service, the present value of that future benefit is subject to FICA taxes in that tenth year. The employer is responsible for withholding and remitting these taxes at the time of vesting.

To prevent double taxation, a “non-duplication rule” accompanies the special timing rule. This provision states that once the SERP benefit has been subjected to FICA taxes at vesting, neither that amount nor any subsequent earnings credited to it will be subject to FICA taxes again when the benefits are eventually distributed. This shields all the investment growth on the vested amount from any future FICA tax liability.

To illustrate, consider an executive whose SERP benefit has a present value of $1 million at the time it vests. In that year, the $1 million is treated as FICA wages. If the executive’s other earnings already exceed the Social Security wage base, only the Medicare portion of the FICA tax would apply to the SERP amount. Years later, when the executive retires and begins receiving distributions from the plan, which may have grown to $1.5 million, those payments will not be subject to any FICA taxes because of the non-duplication rule.

Reporting and Withholding Requirements

When an executive receives a cash distribution from a SERP, the payment is considered wages. The employer must report the gross distribution amount in Box 1 of the employee’s Form W-2 for that year. The employer is also responsible for withholding federal and state income taxes from the distribution, which is reported in Box 2 and the corresponding state box on the Form W-2.

The reporting of FICA taxes reflects the special timing rule. In the year when the SERP benefits vested, the employer reported the present value of those benefits as wages in Box 3 (Social Security wages) and Box 5 (Medicare wages and tips) of the Form W-2 for that specific year. The corresponding Social Security and Medicare taxes withheld would have been reported in Box 4 and Box 6.

Consequently, when the actual cash distributions are made years later, those amounts are not included in Boxes 3 and 5 of the W-2 for the year of payment. To provide clarity to the IRS, employers must also report the distribution amount in Box 11 of the Form W-2, which is designated for nonqualified plans.

The Impact of Section 409A

The tax treatment of SERPs and other non-qualified deferred compensation plans is governed by Section 409A of the Internal Revenue Code. This section imposes a strict set of rules regarding how and when employees can defer compensation and when it can be distributed. Compliance with these rules is a prerequisite for achieving tax-deferral benefits.

Section 409A explicitly limits the permissible events that can trigger a distribution from a SERP. The plan document must clearly define these distribution triggers, and once an election for the timing and form of payment is made, it is generally irrevocable. These events are:

• Separation from service
• Death
• Disability
• A specified time or fixed schedule set at the time of deferral
• A change in control of the company
• An unforeseeable emergency

The consequences of a plan failing to comply with Section 409A, either in its documentation or its operation, fall directly on the executive. If a violation occurs, all vested amounts deferred under the plan become immediately taxable as ordinary income in the current year, regardless of whether the money has been paid out.

Beyond the immediate taxation, Section 409A imposes an additional federal penalty tax equal to 20% of the amount included in income. Furthermore, interest penalties are assessed, calculated at the IRS underpayment rate plus one percentage point, on the back taxes that would have been due had the compensation never been deferred. Strict adherence to Section 409A’s requirements is fundamental to the proper tax treatment of any SERP distribution.