Money Purchase and Profit-Sharing Plans
Not all companies offer money purchase plans, but if they do, the employer is required to contribute to the plan each year on behalf of the participants or employees. In some plans, the employee may also be able to contribute a portion of their income. It was once fairly common to pair these plans with profit-sharing plans, which gives companies the benefit of high input limits and a degree of flexibility in choosing the number of each year’s payments. In other words, employers have a choice of whether to contribute each year to a profit-sharing plan. That was when money purchase plan contribution limits were some of the highest available to employees. Contribution limits have risen over the years for other plans, and there are simpler defined contribution plans available. As a result, most of the pluses of the money purchase/profit-sharing plan combination have decreased the general appeal of money purchase plans for employers. However, money purchase plans can still be an effective way for employees to save for retirement. Alternate names: money purchase pension, money purchase pension plan.
Example of a Money Purchase Plan
If the money purchase plan contribution rate is 5%, workers will receive 5% of their pay in their retirement account each year. If their income increases, so too does the amount added to the account. If an employer does not put in enough to meet the minimum funding standard for the year, they must pay an excise tax.
How Money Purchase Plans Work
Firms of any size can offer money purchase plans to their workers. These plans can be offered alone or along with other types of retirement plans.
Money Purchase Plan Characteristics
Although employers must make a payment to a money purchase plan every year for each worker who is a member of the plan, not all plans allow for employee contributions. However, if employees can contribute, they’re not required to do so, but it can be a powerful way to save for retirement. Money purchase plans can be made simple or complex, depending on the firm’s needs. To set up a plan, all that is needed is for the employer to file Form 5500, “Annual Return and Report of Employee Benefit Plan,” with the Internal Revenue Service (IRS) each year. Small firms may want to get a pre-packaged money purchase plan from a qualified retirement plan provider who administers the plan on the firm’s behalf.
IRS Rules
Like other qualified retirement plans, a money purchase plan comes with IRS rules:
If you switch jobs, you can roll your money purchase plan into a new IRA or 401(k).You must pay a penalty if you withdraw money before you retire.Your employer cannot authorize withdrawals from the account.Your employer may approve loans from the account.
The benefit paid from a money purchase plan is based on the amounts in the account and the gains or losses it has gone through when the participant retires.
How Much Can I Put Into a Money Purchase Plan?
The total annual input to a money purchase plan is the lesser of:
25% of employee earnings; or$57,000 for 2021 and $58,000 for 2022 (the same as the limit for other defined contribution plans)
Contribution rates for highly paid workers can’t outweigh the amounts added for employees who earn less. The IRS conducts “top-heavy” or nondiscrimination tests to decide whether the plans favor certain workers over others. If a money purchase plan appears to favor certain employees over others, the plan may lose its status as a “qualified” plan. Both the employer and employees may have adverse tax consequences.
Money Purchase Plan vs. 401(k)
Pros and Cons of Money Purchase Plans
These plans offer both employers and employees some great advantages but also come with drawbacks.
Pros Explained
Tax benefits: Payments made to money purchase plans are tax-deductible to the employer and tax-deferred for the employees. Investments grow tax-free until money is withdrawn in retirement. The employer’s deduction of a money purchase plan is limited to 25% of the income paid to or earned by eligible plan members. Larger account balances: The required contribution by the employer means that money gets funneled into each employee’s account on an annual basis. Over time, the amounts contributed can grow into a large nest egg. Steady payments: Money purchase plans have to offer a steady value to workers in the form of a life annuity, usually as a monthly benefit over your lifetime. They can also make payments in other forms. Hiring incentive: Money purchase plans offer a savings opportunity for employees and can be a unique selling point in a competitive hiring market. Companies that provide money purchase plans can offer the benefit to new and existing hires, since contributing a percentage of an employee’s pay to their retirement can help create goodwill by bolstering their savings.
Cons Explained
Administrative costs: They tend to come with higher costs, compared with simpler defined contribution plans.Top-heavy test: If a plan looks like it favors people who make more money, you could lose your qualified plan status and the tax benefits that come along with it.Required contributions: The required contribution rate puts firms on the hook for payments even when profits are low, which can put a financial squeeze on a firm during difficult times.Excise tax: Firms must pay an excise tax if they don’t meet the minimum funding standard.
