The Ins and Outs of SERP Swaps

Preserving the wealth in supplemental retirement plans. EXECUTIVE SUMMARY * WHILE NONQUALIFIED SUPPLEMENTAL EXECUTIVE retirement plans (SERPs) are a tax-efficient way to restore benefits lost due to the limits in IRC sections 415 and 401(a)(17), they are not the best way to transfer wealth to the next generation. Multiple taxation and lost earnings can erode up to 85 cents of every dollar transferred to an executive's descendants. * TO HELP EXECUTIVES MAXIMIZE WEALTH FOR FUTURE generations, some companies offer swaps. Executives can swap heavily taxed retirement benefits for tax-favored employer-funded life insurance contracts on the life of the executive or the executive and his or her spouse. * IF AN EXECUTIVE DECIDES TO SWAP EXCESS retirement benefits, the company spends its cost savings on annual premiums for a split-dollar insurance policy. To keep the insurance proceeds tax-free, the executive assigns the policy to an irrevocable trust. * A SWAP CREATES NO ADDITIONAL NET PRESENT VALUE to the company. The exchange also eliminates accrued and future compensation expenses, boosting net income and reducing required proxy disclosures. A company will also have to make certain financial reporting changes to account for the transaction. * TAX-WISE, THE ADVANTAGES OF A SWAP FOR the executive depend on whether or not the exchange triggers income taxation of the benefit or if the IRS changes its position on the taxation of split-dollar life insurance. Using an insurance trust will create gift and possibly generation-skipping tax consequences that an executive should consider carefully before swapping. When Congress enacted legislation restricting qualified retirement benefits, employers responded by creating nonqualified supplemental executive retirement plans (SERPs). These plans provide a tax-efficient way to restore benefits lost due to the restrictions in IRC sections 415 and 401(a)(17). As Congress has continued to lower qualified plan limits, SERPs have become an increasingly important part of a corporate executive's wealth accumulation strategy. Today, it's common for more than 80% of an executive's retirement benefits to be delivered through nonqualified plans. Despite the benefits, many executives with sufficient retirement income are concerned about the tax inefficiency of SERPs as a wealth transfer vehicle. Multiple taxation and lost earnings can erode up to 85 cents of every dollar of income transferred to an executive's descendants. These taxes often include: * Income tax at receipt of benefits. * Income and capital gains taxes as assets accumulate following retirement. * Estate, gift and possibly generation-skipping transfer (GST) taxes at transfer. Many companies are implementing programs to help executives with this tax planning problem. One approach to maximize wealth for future generations and create liquidity to pay estate taxes is called a SERP Also known as a preservation of wealth plan, a benefit exchange or an excess benefit swap, the arrangement allows participants to exchange heavily taxed retirement benefits for employer-funded life insurance contracts. The favorable tax treatment of life insurance can help produce significantly more wealth for future generations. A swap is a complicated financial, tax and accounting strategy. Experienced practitioners must help clients determine what benefits to exchange, plan mechanics and the optimal life insurance arrangement. It's also important for financial managers to understand how these arrangements work so they can help their employers assess the consequences of offering swaps to the company's key executives. THE PLAN MECHANICS An executive's financial position will determine the advisibility of his or her participation in a swap. A participant must be able to maintain a comfortable retirement without the entire SERP, since the decision to forfeit benefits is irrevocable. …