What Is a Money Purchase Plan?

Money Purchase Plans Explained

Definition

A money purchase plan is a type of defined-contribution retirement plan in which an employer is required to contribute a certain percentage of an employee's salary every year.

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Definition and Example of a Money Purchase Plan

A money purchase plan is a type of defined contribution retirement plan. These plans are similar to pension plans in that employers must contribute money to them. Although money purchase plans can work like defined contribution plans, such as 401(k) and 403(b) plans, they have some unique features.

Money Purchase and Profit-Sharing Plans

Not all companies offer money purchase plans, but if they do, the employer is required to contribute to the plan each year on behalf of the participants or employees. In some plans, the employee may also be able to contribute a portion of their income.

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

Contribution limits have risen over the years for other plans, and there are simpler defined contribution plans available. 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. However, money purchase plans can still be an effective way for employees to save for retirement.

Alternate names: money purchase pension, money purchase pension plan.

Example of a Money Purchase Plan

If the money purchase plan contribution rate is 5%, workers will receive 5% of their pay in their retirement account each year. If their income increases, so too 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.

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.

Money Purchase Plan Characteristics

Although employers must make a payment to a money purchase plan every year for each worker who is a member of the plan, not all plans allow for employee contributions. However, if employees can contribute, they're not required to do so, but it can be a powerful way to save for retirement.

Note

Figuring out 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. Employers should seek a finance professional to help in order to meet these payment requirements.

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 Internal Revenue Service (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.

IRS Rules

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; or
  • $57,000 for 2021 and $58,000 for 2022 (the same as the limit for other defined contribution plans)

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

Money Purchase Plan vs. 401(k)

Money Purchase Plan 401(k)
Employers must add a set amount of employees' pay. Employers may elect to match a percentage of funds employees add to the account.
Employee inputs may be allowed but are not required. Employees may elect to put money into an account, but they don't have to.
Offers tax advantages. Offers tax advantages.
Total payments in one year may not go over $57,000 for 2021 and $58,000 for 2022.  Total inputs limited to $57,000 for 2021 and $58,000 for 2022. 
Payments must meet a yearly minimum to avoid an excise tax. Payment limit goes up to $63,500 for catch-up amounts.

With a standard 401(k) or profit-sharing plan, the employer can decide how much will be doled out to its workers each year. Instead of putting in a fixed rate of income, an employer that offers a 401(k) can add a matching amount or percentage of the employee's income based on the amount added by the employee. Likewise, a profit-sharing employer may decide to share a fixed amount of profit and give it to workers each year as a percentage of income.

Pros and Cons of Money Purchase Plans

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

Pros
  • Tax benefits

  • Larger account balances

  • Steady payments

  • Hiring Incentive

Cons
  • Administrative costs

  • Top-heavy test

  • Excise tax

  • Required payments

Pros Explained

  • 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. 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 required contribution by the employer means that money gets funneled into each employee's account on an annual basis. Over time, the amounts contributed can grow into 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 make payments in other forms.
  • Hiring incentive: Money purchase plans offer a savings opportunity for employees and can be a unique selling point in a competitive hiring market. Companies that provide money purchase plans can offer the benefit to new and existing hires, since contributing a percentage of an employee's pay to their retirement can help create goodwill by bolstering their savings.

Cons Explained

  • 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, which 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.

Key Takeaways

  • A money purchase plan is a type of defined contribution retirement plan in which employers contribute a specific amount of employees' earnings each year.
  • Employees may be allowed to contribute money as well.
  • Yearly payments cannot exceed the lesser of 25% of the employee's income or $57,000 for 2021 and $58,000 for 2022.
  • Employers who do not meet minimum input requirements must pay an excise tax.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Internal Revenue Service. "Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits."

  2. Internal Revenue Service. "Choosing a Retirement Plan: Money Purchase Plan."

  3. Bingham, Osborn & Scarborough, LLC. "Profit Sharing & Money Purchase Pension Plans."

  4. Internal Revenue Service. "Publication 560 (2018), Retirement Plans for Small Business."

  5. U.S. Bureau of Labor Statistics. "Defined Contribution Retirement Plans: Who Has Them and What Do They Cost?"

  6. Cornell Law School Legal Information Institute. "26 U.S. Code § 430. Minimum Funding Standards for Single-Employer Defined Benefit Pension Plans."

  7. Internal Revenue Service. "A Guide to Common Qualified Plan Requirements."

  8. Internal Revenue Service. "Fixing Common Plan Mistakes - Top-Heavy Errors in Defined Contribution Plans."

  9. Internal Revenue Service. "401(k) Plan Overview."

  10. Internal Revenue Service. "Choosing a Retirement Plan: Profit-Sharing Plan."

  11. U.S. Department of Labor. "FAQs about Retirement Plans and ERISA," Page 7.

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