What Is a Money Purchase Plan?

Definition & Examples of a Money Purchase Plan

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A money purchase plan is a type of defined-contribution retirement plan in which an employer is required to contribute a certain percentage of an employee's salary every year. Employees may sometimes be required to contribute as well, and yearly contributions cannot exceed a set amount each year.

Learn how money purchase plans work and who can have one.

What Is a Money Purchase Plan?

A money purchase plan is a type of defined-contribution retirement plan offered by some employers. Money purchase plans work like other defined-contribution plans, such as 401(k) and 403(b) plans, but they have some unique features.

An employer that offers a money purchase plan is required to contribute to it every year. The plan will outline a set percentage of the employee's compensation that the employer must contribute to each retirement account every year.

These plans were once commonly paired with profit-sharing plans, which gave companies the benefit of high contribution limits and a degree of flexibility in determining the number of each year's contributions. That was when money purchase plan contribution limits were some of the highest available to employees.

However, contribution limits have risen over the years, and there are simpler defined-contribution plans to choose from, which has removed most of the advantage from the money purchase/profit-sharing plan combination and decreased the general appeal of money purchase plans for employers.

Still, money purchase plans represent a savings opportunity for employees and can be a unique selling point in a competitive hiring market. Companies that have money purchase plans may consider maintaining them for this reason.

Alternate names: money purchase pension, money purchase pension plan

How Money Purchase Plans Work

Businesses of any size can offer money purchase plans to employees. They can be offered alone or in combination with other types of retirement plans.

An employer is required to make a contribution to a money purchase plan every year for each employee who participates in the plan. The employer must contribute a fixed percentage of each eligible employee's salary annually to a separate account.

For example, if the contribution percentage is 5%, the employer must annually contribute 5% of each participating employee's pay to their separate account. If an employer does not contribute enough to meet the minimum funding standard for the year, they must pay an excise tax.

Determining the amount needed to satisfy the minimum funding standard for a money purchase involves a complex calculation based on the value of the plan assets. Employers should seek professional help in order to meet these contribution requirements.

Not all money purchase plans allow for employee contributions. When they do, employees are not required to contribute.

Money purchase plans can be designed simply or made very complex depending on the company’s needs. All that is required is for the employer to annually file Form 5500, "Annual Return/Report of Employee Benefit Plan," with the IRS.

Small companies may consider a pre-packaged money purchase plan from a qualified retirement plan provider who administers the plan on the company’s behalf.

Like other qualified retirement plans, a money purchase plan comes with tax advantages and regulations.

  • If you switch employers, you can roll your money purchase plan over into a new IRA or 401(k).
  • You must pay a penalty if you withdraw money before retirement.
  • Your employer cannot authorize withdrawals from the account.
  • Your employer may authorize loans from the account.

The benefit paid from a money purchase plan is based on the contributions in the account and the gains or losses it has experienced at the time the participant retires.

How Much Can I Contribute to a Money Purchase Plan?

The total annual contribution to a money purchase plan is the lesser of:

  • 25% of employee compensation
  • $57,000 (the same as the contribution limit for other defined-contribution plans)

Contributions for highly paid employees can't outweigh the contributions for lower-paid employees by too much in a money purchase plan or other types of qualified retirement plans. The Internal Revenue Service conducts "top-heavy" or nondiscrimination tests to determine whether the plans favor certain employees over others.

If your money purchase plan appears to show favoritism to certain employees, the plan may lose its status as a "qualified" plan, and both the employer and employees may experience adverse tax consequences.

Money Purchase Plan vs. 401(k)

Money Purchase Plan 401(k)
Employers required to contribute a set percentage of employees' pay. Employers may elect to contribute or match a percentage of contributions
Employee contributions may be allowed but are not required Employees may elect to contribute
Offers tax advantages Offers tax advantages
Total contributions limited to $57,000  Total contributions limited to $57,000
Contributions must meet a yearly minimum to avoid an excise tax Contribution limit increases to $63,500 for catch-up contributions

With a traditional 401(k) or profit-sharing plan, the employer can determine each year how much will be doled out to employees. Instead of contributing a fixed percentage of salary, an employer who oversees a 401(k) can contribute a match for employee contributions. Likewise, a profit-sharing employer may decide to share a fixed amount of profit and distribute it to employees each year as a percentage of salary.

Pros and Cons of Money Purchase Plans

These plans offer both employers and employees some notable benefits but also come with drawbacks.

Pros
  • Tax benefits

  • Larger account balances

  • Steady payments

Cons
  • Administrative costs

  • Top-heavy test

  • Excise tax

  • Required contributions

Pros Explained

  • Tax benefits: Contributions 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. That said, the employer's deduction to a money purchase plan is limited to 25% of the compensation paid to or accrued by eligible employee plan participants.
  • Larger account balances: The required contribution percentage means that money gets funneled into each employee's account on an annual basis—not just when the employer chooses. Over time, the contributions can grow and reward employees with a sizable nest egg.
  • Steady payments: Money purchase plans have to offer a steady benefit to employees in the form of a life annuity, usually as a monthly benefit over your lifetime. They can also distribute payments in other forms.

Cons Explained

  • Administrative costs: They tend to come with higher administrative costs compared with simpler defined-contribution plans.
  • Top-heavy test: If your plan discriminates in favor of highly compensated employees, you could lose your qualified plan status and associated tax benefits.
  • Required contributions: The required contribution percentage puts you on the hook for contributions even when profits are low, which can financially squeeze a business during already difficult times.
  • Excise tax: You must pay an excise tax if you don't meet the minimum funding standard.

Key Takeaways

  • A money purchase plan is a type of defined-contribution retirement plan in which an employer is required to contribute a certain percentage of employees' salaries every year.
  • Employees may be required to contribute as well.
  • Yearly contributions cannot exceed the lesser of 25% of the employee's salary or $57,000.
  • Employers who do not meet minimum contribution requirements must pay an excise tax.

Article Sources

  1. Internal Revenue Service. "Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits." Accessed July 17, 2020.

  2. Internal Revenue Service. "Choosing a Retirement Plan: Money Purchase Plan." Accessed July 17, 2020.

  3. Bingham, Osborn & Scarborough, LLC. "Profit Sharing & Money Purchase Pension Plans." Accessed July 17, 2020.

  4. Internal Revenue Service. "Publication 560 (2018), Retirement Plans for Small Business." Accessed July 17, 2020.

  5. Cornell Law School Legal Information Institute. "26 U.S. Code § 430. Minimum Funding Standards for Single-Employer Defined Benefit Pension Plans." Accessed July 17, 2020.

  6. U.S. Bureau of Labor Statistics. "Defined Contribution Retirement Plans: Who Has Them and What Do They Cost?" Accessed July 17, 2020.

  7. Internal Revenue Service. "A Guide to Common Qualified Plan Requirements." Accessed July 17, 2020.

  8. Internal Revenue Service. "Fixing Common Plan Mistakes - Top-Heavy Errors in Defined Contribution Plans." Accessed July 17, 2020.

  9. Internal Revenue Service. "401(k) Plan Overview." Accessed July 17, 2020.

  10. Internal Revenue Service. "Choosing a Retirement Plan: Profit-Sharing Plan." Accessed July 17, 2020.

  11. U.S. Department of Labor. "FAQs about Retirement Plans and ERISA," Page 7. Accessed July 17, 2020.