Money purchase plan

What Is Money Purchase Plan?

A money purchase plan is a type of employer-sponsored retirement plans that falls under the category of defined contribution plan. It requires an employer to contribute a fixed percentage of an eligible employee's compensation to their retirement account each year, regardless of the company's profitability. This contrasts with other defined contribution plans where employer contributions might be discretionary. Money purchase plans offer significant tax advantages for both employers and employees, making them a component of effective retirement planning. The plan's assets grow on a tax-deferred growth basis, meaning taxes are typically paid only upon withdrawal during retirement³⁹.

History and Origin

The concept of employer-provided pensions in the United States dates back to the late 19th century, with the American Express Company establishing one of the first private employer plans in 1875.³⁸ Early pension arrangements were often discretionary, allowing employers to modify or terminate them at any time. The landscape of private retirement plans, including money purchase plans, underwent significant transformation with the enactment of the Employee Retirement Income Security Act of 1974 (ERISA).³⁶, ³⁷ This landmark federal law set minimum standards for most voluntarily established retirement plans in private industry, aiming to protect the interests of plan participants and their beneficiaries.³⁵ ERISA imposed requirements for participation, vesting, benefit accrual, and funding, increasing the cost and regulatory burden for employers offering certain types of plans.³⁴

Key Takeaways

• A money purchase plan mandates fixed annual employer contributions, often as a percentage of an employee's salary.³², ³³
• These plans are considered defined contribution plans, meaning the employee's retirement benefit depends on contributions and investment performance.³¹
• Contributions and earnings grow on a tax-deferred basis until retirement.³⁰
• Employers can deduct their contributions, and employees generally do not pay tax on contributions until withdrawal.²⁹
• Money purchase plans are subject to strict regulations by the Internal Revenue Service (IRS) and the Department of Labor.²⁸

Formula and Calculation

The formula for an employer's contribution to a money purchase plan is relatively straightforward:

$\text{Employer Contribution} = \text{Contribution Rate} \times \text{Eligible Employee Compensation}$

Where:

• Contribution Rate refers to the fixed percentage (e.g., 5%, 10%) stipulated in the plan document that the employer commits to contributing annually.²⁷
• Eligible Employee Compensation is the employee's annual salary or wages, up to a specified limit set by the IRS for qualified plans. For 2024, the maximum compensation that can be taken into account for calculating contributions and benefits is \($345,000\), increasing to \($350,000\) for 2025.²⁶

For instance, if a money purchase plan specifies a 10% contribution rate, an employer would contribute 10% of each eligible employee's annual salary to their individual account. A participant's benefit at retirement is based on the total contributions to their account and the gains or losses from investments.²⁵

Interpreting the Money Purchase Plan

Interpreting a money purchase plan primarily involves understanding the fixed nature of employer contributions and the individual nature of employee accounts. Unlike a traditional defined benefit plan, where a specific retirement benefit is guaranteed, a money purchase plan's payout is determined by the cumulative contributions and the investment performance within each participant's account. This means participants bear the investment risk associated with the plan's assets, as the value of their account can fluctuate with market conditions.²⁴

Employees should review the plan's vesting schedule, which dictates when they gain full ownership of the employer contributions. If an employee leaves employment before being fully vested, they may forfeit a portion of the employer's contributions. The plan typically offers various investment options, allowing employees to choose how their funds are allocated, similar to many modern retirement vehicles.²³

Hypothetical Example

Consider XYZ Corp., which establishes a money purchase plan for its employees with a mandatory employer contribution rate of 5% of each eligible employee's annual salary. Sarah earns an annual salary of $75,000.

In this scenario, XYZ Corp. is required to contribute 5% of Sarah's $75,000 salary to her money purchase plan account each year.

• Annual Employer Contribution for Sarah = 5% of $75,000 = $3,750

This $3,750 will be deposited into Sarah's individual retirement account within the money purchase plan. Over time, these annual contributions, combined with any investment returns (or losses) on the accumulated funds, will determine the total value of her retirement savings. Sarah might also be permitted to make her own contributions, depending on the plan's design. The funds in her account would grow tax-deferred until she begins taking distributions, typically in retirement. This example illustrates the predictable, fixed contribution characteristic of a money purchase plan, distinguishing it from other types of retirement plans where contributions might vary.

Practical Applications

Money purchase plans are primarily used by employers seeking a retirement savings vehicle that offers predictable, mandatory contributions. They are a suitable choice for businesses looking to provide a structured retirement benefit for their employees. These plans appear in various business settings, from small businesses to larger corporations, as a means of attracting and retaining talent by offering a valuable employee benefit.

The Internal Revenue Service (IRS) outlines the rules and limits for these plans in publications such as Publication 560, Retirement Plans for Small Business, which provides detailed guidance on contribution limits, deductions, and reporting requirements.²¹, ²² Money purchase plans can be combined with other retirement structures, including 401(k) plans_plans) and defined benefit plans, to create a comprehensive retirement benefits package.²⁰ While less common than some other defined contribution plans today, they remain a viable option under specific circumstances, providing a framework for consistent savings for an employee's future.

Limitations and Criticisms

While money purchase plans offer benefits, they also come with certain limitations and criticisms, primarily from the employer's perspective. A significant drawback for employers is the mandatory nature of contributions. Unlike a profit-sharing plan, where employer contributions can be discretionary and tied to company profitability, a money purchase plan requires the employer to make the predetermined fixed contribution annually, regardless of the business's financial performance.¹⁸, ¹⁹ This can pose a heavy financial burden during lean years or periods of economic downturn, and failure to meet the minimum contribution requirement can result in an excise tax.¹⁶, ¹⁷

Historically, the inflexibility of mandatory contributions made money purchase plans less popular than profit-sharing plans after the passage of ERISA.¹⁵ Furthermore, money purchase plans often incur higher administrative and overhead costs compared to other types of defined contribution plans, due to the need for annual filing of Form 5500 and adherence to complex regulations.¹², ¹³, ¹⁴ While employees typically benefit from guaranteed employer contributions, the fiduciary duty and administrative complexities can be a notable challenge for the sponsoring employer.

Money Purchase Plan vs. Profit-Sharing Plan

The primary distinction between a money purchase plan and a profit-sharing plan lies in the employer's contribution obligation. Both are types of defined contribution plans, but their contribution structures differ fundamentally.

A money purchase plan commits the employer to a predefined contribution rate, offering employees a stable and predictable stream of retirement savings. In contrast, a profit-sharing plan provides the employer with greater flexibility, allowing contributions to fluctuate based on the company's financial success.⁶ This flexibility is a key reason why profit-sharing plans have gained broader adoption over money purchase plans in recent decades.

FAQs

Can an employee contribute to a money purchase plan?

While the employer is required to make contributions to a money purchase plan, employees may also be permitted to contribute, depending on the specific terms of the plan. These employee contributions often supplement the mandatory employer contributions.

What are the withdrawal rules for a money purchase plan?

Withdrawal rules for money purchase plans are generally similar to those for other qualified retirement plans. Typically, participants can begin withdrawing funds penalty-free at age 59½. Early withdrawals before this age may be subject to a 10% penalty in addition to ordinary income tax, unless an exception applies. ⁴, ⁵Distributions can often be taken as a lump sum or through periodic payments.
², ³

Are money purchase plans still common?

Money purchase plans are less common today than other defined contribution plans like 401(k)s or profit-sharing plans, largely due to their fixed contribution requirement, which offers less flexibility for employers. However, they are still a viable option for businesses that prefer a mandatory, consistent contribution structure.

Can a money purchase plan be rolled over into another retirement account?

Yes, if an employee leaves their employer, the funds in their money purchase plan account can typically be rolled over into another qualified retirement plan, such as a 401(k) or an individual retirement account (IRA). ¹This allows for the continued tax-deferred growth of the retirement savings.