Considering a money purchase pension plan? Before you set one up, make sure you read this complete guide. We’ll explain the key features and also offer some words of caution.
It’s not that these are bad plan retirement plans. But when you consider the lack of flexibility and rather small contributions, there just is not much of a compelling reason to set one up. But we’ll let you decide for yourself.
Once we get through all the main features and benefits, we’ll point out 3 reasons why you might want to think twice about setting up a plan. Let’s dive in.
Table of contents
- What is a money purchase plan?
- How does a money purchase plan work?
- Is it similar to a 401(k)?
- How does it differ from a profit-sharing plan?
- What is the contribution limit?
- Can you rollover funds into an IRA?
- What about distributions and withdrawals?
- Do they allow vesting?
- 3 Reasons to Think Twice
- Bottom Line
What is a money purchase plan?
Money purchase plans are often confused with cash balance plans and profit-sharing plans. In reality, they are a type of defined-contribution plan that most closely resembles a profit-sharing plan.
But there is one large difference. 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.
Here are some key features of money purchase plans:
- Contributions are required. The employer MUST make plan contributions each year for plan participants.
- The plan will state upfront the required contribution percentage. For example, the plan document might require a contribution of 10% of eligible employee compensation. The employer is required to place this amount into a separate employee account.
- An employee’s ultimate benefit is based on the account contributions and the cumulative gains or losses in the account at retirement.
- They can be combined with other retirement plans like cash balance plans and defined benefit plans.
- They do allow for some customization based on maximum contribution levels.
- Employer contributions are tax-deductible as long as they are within annual limits and made on an annual basis.
- Businesses of any size can adopt a plan.
- They require annual filing of form 5500, but generally have minimal reporting requirements.
- Loans are permitted, but in-service distributions are not.
- Significant tax penalties can occur if minimum contributions are not met.
How does a money purchase plan work?
Money purchase plans are qualified plans. As such, they can be set up much like other retirement structures. A third-party administrator can set up the plans and monitor annual compliance.
The real key is that the employer has to establish set contribution amounts upfront. So the company must do some budgeting and determine how much of a contribution it can afford and structure the plan accordingly.
The upfront analysis can be a little more daunting. Once plans are set up, contributions can be made up to the date the tax return is filed, including extensions.
Because employees are not allowed to make plan contributions, money purchase pension plans are usually offered in conjunction with other types of retirement plans, like a 401(k). This can give employees a nice boost to their retirement savings.
Is it similar to a 401(k)?
No it is very different. Money purchase pension plans only allow employer contributions. Employees are not allowed to do a salary deferral to the plan.
However, like most 401(k) plans, employees are allowed to choose how to invest the money in their account. These options do vary based on options specified by the plan. Just like a 401k, contributions grow tax-deferred and are not taxable to the employee until withdrawn.
How does it differ from a profit-sharing plan?
With a profit-sharing plan, the employer can decide to make a flat dollar contribution of, for example, $20,000. Then, based on the contribution formula, the $20,000 is allocated to the employee’s individual accounts.
Years back, these plans plans had higher tax-deductible limits than profit-sharing plans were allowed. But unfortunately, this is no longer the case.
What is the contribution limit?
As stated, employers are required to make annual contributions that is specified in the plan document. For calendar year 2020, an employee can receive up to 25% of compensation or $57,000 (whichever is lower). The limits are similar to 401k plans.
Can you rollover funds into an IRA?
Consistent with other retirement structures, employees who leave the company are allowed to rollover their money purchase plan funds into a 401(k), 403(b), or IRA.
What about distributions and withdrawals?
Employees may typically withdraw their plan assets in a lump sum or as periodic payments. Any distribution is taxed as ordinary income. Any withdrawals made before age 59½ will be subject to the 10% early distribution penalty (unless an exception is met). In addition, money purchase plans are subject to the required minimum distributions (RMDs).
Do they allow vesting?
Employers have the ability to require employee vesting. This requires the employees to work for a specific number of years before they have “ownership” of the funds in their account.
When employees become fully vested, they can begin to take withdrawals upon reaching the age of 59½. At this point they are not subject to a tax penalty.
3 Reasons to Think Twice
These plans can work fine in the right situation. But ma sure you consider the following:
#1 – Contributions are fixed and not variable
Since contributions are fixed, a big difference is plan flexibility. A profit-sharing plan provides employers with the ability to adjust annual contributions based on overall company profitability.
But in contrast, money purchase pension plans require annual contributions. These contributions are a fixed percentage regardless of company profitability.
#2 – Higher administrative costs
The truth is that many third-party administrators just don’t understand much about how these plans work. Also, you need to consider carefully what the annual contributions will be upfront. This all leads to added complexity.
When a plan is more complex, the annual administration fees will increase. You will find that many plans may have twice the fees compared to the average profit-sharing plan.
#3 – Lower Contributions Levels
If the goal is to maximize plan contributions, then usually a defined benefit plan or cash balance plan is a better option. If you do a cost comparison you will see that money purchase plans can be a little cheaper but certainly don’t come close to meeting the higher contribution levels.
The following are some important consideration when setting up a money purchase plan:
- A participant account balance can be rolled over into profit sharing plan or other qualified retirement plan upon termination.
- Like any defined contribution plan, they have flexible Investment options and can have a vesting schedule based on years of service.
- Retirement income will be based on yearly employee contributions and investment returns (like an individual retirement account).
- In lean years with poor financial results, retirement contributions must still be made to avoid excise taxes.
- The employee’s account will grow based on the employee’s salary (compensation) and the rate specified during the plan design.
- Plans can be established at plenty of financial institutions on behalf of employees.
|They can be combined with other retirement structures, including defined benefit plans and 401(k)s.||Employer contributions are fixed and NOT elective.|
|Contributions are tax-deductible.||Contributions are not as high as defined benefit plans.|
|Because amounts are fixed, employers can budget for contributions.||Not favorable for companies with many employees.|
|They can be combined with 401h accounts for tax-free medical.||Require form 5500 (unless exceptions are met).|
If you are a business owner and looking to set up a retirement structure, you can certainly consider a money purchase plan. But there really just not a lot of reasons to consider the plans. Make sure you check with your CPA or financial advisor.
When you think of the flexibility of profit-sharing plans and the large contributions allowed by cash balance plans and defined benefit plans, you should certainly think closely about it.