Executive employment relationships are rarely permanent. When an executive or other senior-level employee terminates employment, companies often must deal with difficult tax, equity, and benefits issues that arise in connection with the employee’s termination.
This article is the fourth in a series of articles that address important compliance pointers for structuring post-termination benefits or addressing issues and considerations for companies when an executive terminates employment. In our previous articles we discussed whether ERISA applies to your executive severance plan, whether Code Section 409A applies to severance benefits, and what to do about equity awards.
This month, we are discussing issues to consider before promising certain post-termination benefits to an executive in their employment or separation agreements.
Retirement Plan Promises
A common, yet problematic, promise we see in separation agreements is that the terminating executive may contribute some or all of their severance pay to their 401(k) or 403(b) plan accounts. This is an understandable mistake, as many 401(k) or 403(b) plans generally permit plan participants to make deferrals from all of their taxable compensation. However, there is a special rule in section 415 of the Internal Revenue Code of 1986, as amended (the Code), that prohibits severance pay from being considered eligible pay under 401(k) and 403(b) plans. Since this is a legal rule, there is no way to “draft around it.”
Another promise, although rarer, is that the executive will become vested in their retirement plan benefits upon their termination of employment. While this promise is not necessarily prohibited by a legal rule, for tax-qualified retirement plans, such as 401(k) or pension plans, and for non-governmental 403(b) plans, this promise may be considered discriminatory in violation of Code rules if the terminating executive is considered highly compensated under these rules (for 2025, generally includes those employees who earned more than $160,000 in 2024, with that amount indexed each year). To solve this issue, the employer could simply pay additional severance benefits equal to the unvested amount that is otherwise forfeited under the retirement plan. However, that severance payment will not be eligible for the same tax-favored treatment that the executive would have enjoyed had the payment been made under the retirement plan, such as the ability to rollover the payment and avoid immediate income taxes.
The above concern with promised vesting does not apply to nonqualified retirement plans, which already favor higher-paid employees and are not subject to the same nondiscrimination rules as tax-qualified retirement plans. A nonqualified plan may provide for full vesting for some participants and not others, so an employer may provide additional vesting under these plans on an individual basis.
Health Plan Promises
It is typical for an employment or separation agreement to promise continued post-termination group health plan participation, such as continued free or subsidized coverage under the employer’s health plans.
The best way to draft such a provision is to tie it to COBRA coverage, since the employer’s group health plan will already have provisions entitling a terminated employee to continue coverage under COBRA. As an example, the provision might say that if the terminated executive timely elects COBRA coverage, then the employer will pay (or reimburse the executive for) some or all of the executive’s COBRA premiums while such COBRA coverage is in effect. We recommend this approach, especially for plans that either are insured or are self-insured with stop-loss insurance, so the employer does not inadvertently make promises to the executive that their insurance carriers have not agreed to (such as permitting a terminated executive to continue coverage without making a COBRA election).
If the promised post-termination coverage extends beyond the typical 18-month COBRA coverage period, then the employer should seek approval from their health plan’s insurance or stop-loss carrier, if applicable, to ensure that the extended benefits will remain covered by the insurance policy. In addition, because ERISA requires plan documents to specify when benefits are paid, the employer should ensure that the plan permits a terminated employee to continue coverage beyond the COBRA continuation period, such as by including a provision in the plan that coverage may be extended to the extent set forth in a separation agreement.
Finally, for self-insured plans, federal income tax consequences must be considered when making any promises to a departing executive. Self-insured group health plans are subject to Code section 105(h), which requires benefits to be taxable to the employee if the plan discriminates in favor of highly-paid employees or former employees. If the employer provides COBRA subsidies only to terminating executives and not to rank-and-file employees, then the terminating executives could be subject to taxation on the post-termination benefits. To avoid taxation of the benefits, the employer could instead impute the value of the employer’s COBRA subsidy as taxable wages for the executive. Of course, withholding taxes are due on those imputed wages, and if there is no cash severance being paid during the same period as the subsidized health plan coverage is in effect from which to make those withholding payments, then the employer and executive will need to come to an arrangement about how those withholding taxes will be paid. Another alternative is to provide the executive with additional taxable cash compensation payments that the executive can choose to use to cover their COBRA costs if they wish, instead of specific subsidies or reimbursements tied to the executive’s enrollment in COBRA coverage.
Other Welfare Plan Promises
The final typical, but problematic, promise we often see in employment or separation agreements is that the terminated executive may continue participation in “all of the employer’s welfare plans” for some post-termination period. The phrase “employer’s welfare plans” would include such things as life insurance and long-term disability plans, as well as group health plans (which we already discussed above).
The concern is that life insurance and long-term disability plans rarely have post-termination coverage provisions like COBRA. Life insurance plans often only permit terminated employees to convert their group coverage to an individual insurance policy (subject to caps on the amount that can be converted, as well as often significantly higher premium obligations) and long-term disability plans often have no concept of post-termination coverage of any sort. Therefore, before promising these post-termination benefits, it is imperative that the employer review the rules of its benefit plans and insurance policies to determine if there is a way to provide such coverage, or seek approval from the insurance carrier to add a rider to the policy to extend the coverage to the executive. Otherwise, the employer may have inadvertently promised benefits it will need to self-insure because the insurance carrier has not agreed to pay those benefits under its policy. For example, if the former executive were to die while promised post-termination group life insurance coverage is purportedly in effect, the insurer could deny the claim for benefits, resulting in the employer having to pay the death benefits from its general assets.
In summary, before promising post-termination benefits in an executive’s employment or separation agreement, the employer must consider whether the law and the terms of its plan documents or insurance policies allow those promises to be kept, and, if so, how to deal with the tax consequences. Employers should carefully consider these issues before entering into employment agreements with or making promises to a terminating executive to avoid these unintended consequences.
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