There’s a retirement plan in the IRS playbook that gets little attention. It’s called a money purchase pension plan and it can work exceptionally well in the right situation.
Most business owners assume retirement contributions naturally ebb and flow with the business. Money purchase plans don’t — and that single design choice changes everything about how the plan should be sized, written, and adopted.
This article walks through what solo business owners needs to understand before signing the adoption agreement. We’ll cover the compliance issues and how it works if you have W2 compensated or if you are taxed as a sole proprietor.
Money Purchase Plan Basics
A money purchase plan is a type of defined contribution retirement plan in which an employer is required to make fixed annual contributions to each eligible employee’s individual account.
The contribution is typically expressed as a percentage of the employee’s compensation (for example, 5% of salary each year), and once the formula is established in the plan document, the employer is legally obligated to fund it every year.
This mandatory funding requirement is the defining feature that distinguishes money purchase plans from profit-sharing plans, where contributions can be discretionary.
Annual contribution limits follow IRS rules for defined contribution plans, generally capped at the lesser of a set dollar amount or 100% of the employee’s compensation.
Money purchase plans were more popular before 2002, when they offered higher deductible contribution limits than profit-sharing plans. After the Economic Growth and Tax Relief Reconciliation Act equalized the limits, many employers converted their money purchase plans into profit-sharing plans to gain flexibility, since profit-sharing plans allow contributions to vary year to year based on business performance.
Complexities
Contributions to a money purchase plan are not based on your business profits. A money purchase plan could require that contributions are based on 10% of the participants’ compensation without regard to whether there are any business profits.
That’s the defining feature of a money purchase pension plan — contributions are mandatory and formula-driven, not tied to profits. Contribution amounts are fixed and NOT variable.
As such, an employer is required to make annual contributions. The plan document establishes a set contribution level that is based on employee compensation. Your 10%-of-comp example is exactly how it works: if the plan document says 10%, the employer owes 10% of each eligible participant’s compensation every year, full stop. Contributions to a money purchase plan must be made every year, regardless of earnings or profits.
This is the whole reason money purchase plans exist as a separate animal from profit-sharing plans. A profit-sharing plan provides employers with the ability to adjust annual contributions based on overall company profitability.
Money purchase plans don’t give you that flexibility — that’s the trade-off for the structure and predictability they offer employees. Skip a contribution and you can trigger excise taxes and risk the plan’s qualified status.
Differences Between Profit Sharing and Money Purchase
The seasoned money rules — the 2-year rule and the 5-year rule — are a creature of profit-sharing plans only. They come from a line of older revenue rulings (54-51, 60-83, 61-164) that all dealt with profit-sharing plans, and they’ve never been extended to pension plans of any flavor.
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A special rule applies to the profit-sharing type of defined contribution plans, such as 401(k)s. These plans may restrict the amount used to purchase life insurance to “seasoned money” — that is, money that has accumulated in the account for a fixed number of years. Money purchase plans aren’t profit-sharing plans, so the seasoned money exception isn’t on the menu.
A money purchase plan is a defined contribution plan structurally, but it’s still classified as a pension plan under the Code and regulations — that’s why contributions have to be definitely determinable and mandatory.
For incidental benefit purposes, the IRS treats it the same as any other pension plan: it lives under Rev. Rul. 74-307’s 50% (whole life) and 25% (term/UL) rules applied to the employer contributions credited to each participant’s account. No seasoning exception, no after-2-years free pass, no after-5-years unlimited window. Just the percentage caps, year in and year out.
Why the asymmetry exists
The reason profit-sharing plans got the seasoned money exception in the first place is rooted in their historical ability to make in-service distributions. The IRS’s logic was essentially: if a participant could withdraw seasoned funds from the plan and use them to buy life insurance personally, there’s no policy reason to stop the trust from doing the same thing on their behalf.
That logic only works for plans that can distribute in-service. Money purchase plans — as pension plans — generally can’t make in-service distributions before age 62, retirement, death, disability, or termination. So the underlying rationale for seasoning never applied to them, and the IRS never built the bridge.
One practical consequence
This makes money purchase plans a meaningfully less attractive vehicle for life insurance funding than profit-sharing plans, especially for participants with long tenure. In a profit-sharing plan, a participant who’s been in for six or seven years with substantial seasoned dollars can fund a real policy without bumping against the 50% ceiling.
One Nuance for the Self-Employed
For a W-2 employee, “compensation” is their wages, which they get paid whether the business made money or not, so the contribution is genuinely independent of profits. But for a sole proprietor or partner, the contribution percentage applies to “earned income”. This is basically net self-employment income after the deduction for half of SE tax and the plan contribution itself.
Is a Cash Balance or Defined Benefit Plan Right For You?
If a self-employed person has a loss for the year, there’s no earned income to multiply by 10%, so there’s nothing to contribute for that owner. That’s not the plan flexing based on profits, though — it’s just that the math has nothing to grab onto. The mandatory contribution for any W-2 employees of that business is still owed.
Money purchase contributions are profit-blind by design. The only place “did I make money” sneaks back into the picture is when the participant is the business owner and “compensation” for them means earned income, which can be zero or negative in a bad year.
Final Thoughts
The takeaway is short and worth committing to memory before plan-design season: money purchase pension plans are profit-blind by design. The percentage in your plan document is what you owe each year, regardless of whether the business had its best quarter or its worst. That’s a feature, not a bug — but only if you sized the percentage correctly when you set the plan up.
If you’re considering one, model the contribution against your worst plausible year, not your best. Look at the percentage and ask honestly: “Could I write this check if revenue dropped 30%?” If the answer is no, either pick a smaller percentage or pick a different plan.
A profit-sharing plan gives you the flexibility to dial contributions up or down with the business. A money purchase plan does not. And if you’ve already adopted one and the formula is biting harder than expected, talk to your TPA about whether an amendment or termination makes sense before the next plan year locks in.
For the right business — steady cash flow, an owner who values discipline, and employees who appreciate predictability — a money purchase plan is a quietly powerful tool. The mandatory nature isn’t a flaw; it’s the whole point. It forces savings to happen in the years when it’s most tempting to skip them. Just go in with eyes open: when the plan document says 10%, the IRS isn’t grading on a curve. The number on that page is the number you owe.
