• American Financial Partner

What Is a Money Purchase Plan?

Updated: Sep 14, 2021

A money purchase plan is a type of retirement plan in which an employer must add a certain percentage of an employee's earnings every year. Employees may also be required to contribute as well. Yearly contributions cannot exceed a set amount each year.

They are a bit like a pension since employers have to put money in them. Learn how money purchase plans work and who can have one.

Definition and Examples of a Money Purchase Plan

A money purchase plan is a type of defined contribution retirement plan. Not all jobs offer them, but some do. These plans work like other defined contribution plans, such as 401(k) and 403(b) plans, but they have some unique features.

A job that offers a money purchase plan must add funding to it every year. The plan will outline a set amount of the employee's earnings that must be put into a retirement account every year.

It was once fairly common to pair these plans with profit-sharing plans. This gives companies the benefit of high input limits and a degree of flexibility in choosing the number of each year's payments. That was when money purchase plan contribution limits were some of the highest available to employees.

Contribution limits have risen over the years, and there are simpler defined contribution plans to choose from. 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.

Still, money purchase plans offer a savings opportunity for employees and can be a unique selling point in a competitive hiring market. Firms that provide money purchase plans may decide to keep them for this reason.

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.

An employer must make a payment to a money purchase plan every year for each worker who is a member of the plan. The employer must put in a fixed amount of each employee's salary each year into a separate account.

For instance, if the contribution rate is 5%, workers will receive 5% of their pay in their account each year. When their pay goes up, so 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.

Not all money purchase plans are set up to let employees add extra money into them. When they are set up this way, employees are not forced to do so, but it is a nice option.

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 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.

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.

  • $57,000 (the same as the limit for other defined contribution plans).

Contribution rates for highly paid workers can't outweigh the amounts put in 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.

Pros and Cons of Money Purchase Plans

These plans offer both employers and employees some great gains but also come with drawbacks.

Pros:

  • 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. That said, 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 needed payment amount means that money gets funneled into each employee's account on an annual basis. Money is not just added when the firm chooses. Over time, the amounts put in can grow and reward workers with 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 give out payments in other forms.

Cons:

  • 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. This 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.

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