What Is a Money Purchase Plan?
Learn what sets this plan apart from 401(k) and other qualified plans
A money purchase plan, also known as a money purchase pension 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. Understanding what money purchase plans require and offer participants is a must if you're considering establishing or contributing to one.
Money Purchase Plan Contribution Type
When comparing a money-purchase plan versus a traditional 401(k) plan, the two are similar in that either the employer and employee can make contributions to the plan. However, not all money purchase plans allow for employee contributions, and when they do, employees are required to contribute. In contrast, an employer is required to make a contribution to a money purchase plan every year for each employee who participates in the plan, whereas employers can elect, but aren't required, to contribute to a traditional 401(k) or profit-sharing plan.
Moreover, a money purchase plan differs in that the plan establishes a required contribution percentage. The employer must, therefore, 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 his or her separate account.
In addition, these plans require you to contribute enough to meet the minimum funding standard for the year or else 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, so you should seek professional help in order to meet these contribution requirements.
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.
Money purchase plans require employers to put a fixed percentage of salary into a separate account for each employee participating in the plan.
Money Purchase Plan Contribution Limits
The total annual contribution to a money purchase plan is the lesser of 25% of employee compensation or $57,000 for 2020. The latter figure is 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.
Pros and Cons of Money Purchase Plans
These plans offer both employers and employees some notable benefits.
- They offer 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.
- They may result in larger account balances over time. 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.
- They offer steady payments to employees. Money purchase plans have to offer a benefit in the form of a life annuity, usually as a monthly benefit over your lifetime. They can also distribute payments in other forms.
However, these plans are not without their drawbacks.
- They tend to come with higher administrative costs compared with simpler defined-contribution plans.
- They impose top-heavy testing. If your plan discriminates in favor of highly compensated employees, you could lose your qualified plan status and associated tax benefits.
- They may result in an excise tax. You would be on the hook for this tax if you don't meet the minimum funding standard.
- They force you to contribute when you don't have the funds. 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.
Eligibility for a Money Purchase Plan
Businesses of any size can offer money purchase plans to employees, and can even offer them in combination with other types of retirement plans.
Moreover, they 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.
Final Thoughts on Money Purchase Plans
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.
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