A money purchase pension plan can be an option for you if you own a firm and want to recruit staff from bigger companies that provide a variety of retirement plans. It gives you the added benefit of tax deductions while enabling you to make substantial contributions on behalf of your employees.
What is a Money Purchase Plan ?
A money purchase plan is an employer-sponsored retirement plan that requires companies to contribute a specific percentage of an employee’s salary each year, regardless of profitability.
A money purchase pension plan is a type of defined contribution retirement plan. These programs are comparable to pension plans in that employers are required to make financial contributions. Money purchase plans have certain distinctive characteristics, despite the fact that they can function similarly to defined contribution plans like 401(k) and 403(b) plans.
Employers who create money purchase plans are required to specify an annual contribution level in the plan agreement that is based on employee salaries. Companies may make contributions of up to 25 percent of the combined annual compensation of all plan participants, up to 100 percent of each participant's salary, or up to $66,000 in 2023, whichever is less.
The employee may select how to invest the money based on alternatives provided by the employer but is not allowed to make contributions to the fund. In a money purchase pension plan, the employer's contribution is tax deductible, but the employee's account balance is not taxed until it is withdrawn.
Key Facts of Money Purchase Plan
- An yearly company contribution to the retirement savings of its employees is made through the money purchase pension plan.
- Every year, the employer is required to contribute to the account a certain portion of the participating employee's salary.
- For 2023, annual payments cannot be more than $66,000 or 25% of the employee's income.
- Employees may have 401(k) plans as well, but they are not required to contribute to their pension plans.
- Due to the fact that this retirement savings plan is "qualified," the employee won't be taxed on the funds until they are withdrawn.
- Like other qualified retirement plans, money purchase plans are subject to their own set of IRS rules.
- Establishing a plan only requires the company to annually file Form 5500, "Annual Return and Report of Employee Benefit Plan," with the IRS.
- You can transfer your money purchase plan into a new IRA, deferred annuity, or 401(k), if you change jobs.
- In addition to regular taxes, you must pay a penalty of 10%, if you withdraw your money before retiring.
- Upon retirement, the entire amount in the account may be taken in lump amounts or used to buy a lifetime annuity.
How Does Money Purchase Plan Work ?
In a defined-contribution retirement plan known as a money purchase plan, the employer is required to make annual contributions equal to a certain portion of the employee's pay.
As long as the amounts are within annual restrictions, employer contributions are tax-deferred. Employee funds accumulate tax-deferred until withdrawn, much like in other defined-contribution plans. It's significant to note that employees are not permitted to make additional contributions to their own accounts. They frequently have the option to decide which investments go into their accounts, though.
Employers frequently establish vesting schedules that specify when an employee may make a claim for funds under his or her plan. Employees who have reached full vesting are permitted to start taking withdrawals when they turn 59½ without paying a federal tax penalty. If a situation qualifies as a "qualifying event", as specified in the plan document, employees may also draw from their plans before turning age 59½.
Withdrawals can be made as a lump payment or in minimum yearly instalments based on life expectancy, and they must start once the account holder becomes 72. Withdrawals are taxed as regular income.
IRS Rules
An IRS rule applies to money purchase plans just like it does to other qualified retirement plans :
- You can transfer your money purchase plan into a new IRA or 401(k) if you change job.
- If you take money out before you retire, you must pay a penalty.
- The account cannot be withdrawn from by your employer.
- Loans from the account may be approved by your employer.
- Need to annually file Form 5500.
When a participant in a money purchase plan retires, the benefit they receive is determined by the balances in their account and any profits or losses they have experienced.
Example of Money Purchase Plan
Employees who participate in a money purchase plan will annually receive 5% of their pay in their retirement account if the contribution rate is 5%. The amount added to the account increases along with their salary. Employers are required to pay an excise tax, if their contributions fall short of the required minimum level for the year.
Eligibility of Money Purchase Plan
Any size of firms can offer money purchase plan to their employees. These plans can be provided separately or along with other types of retirement plans. To set up a money purchase 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.
No of the size, any business can provide a money buy pension plan. To increase the amount of annual contributions that are permitted, businesses may offer it in conjunction with other contribution retirement plans. Small-sized companies may take pre-packed plans from authorized retirement plan suppliers. In such cases, the plan provider administers the money purchase pension plan on behalf of the company.
What is the Contribution Limit for Money Purchase Plan ?
The IRS has set annual limits for all company and employee contributions to money purchase plans. The restrictions for 2023 are the lesser of :
Money purchase plan maximum contribution :
- 25% of compensation, or
- $66,000 in 2023 ($61,000 for 2022, $58,000 for 2021, subject to cost-of-living adjustments).
The contribution rates of highly compensated employees cannot exceed the contributions made by lower-paid employees. To determine whether the programs favor some employees over others, the IRS performs "top-heavy" or nondiscrimination tests. A plan is deemed top-heavy if more than 60% of its total assets are owned by the company's owners and highly compensated employees. If a business is discovered to have a top-heavy plan, the plan may no longer qualify as a "qualified plan", which would subject the employer and the participating employees to severe tax penalties.
Withdrawal Rules of Money Purchase Plan
The retirement benefit for the member is determined by the total contributions made as well as investment profits or losses. The funds are tax-deferred as long as the contribution sums stay under the annual caps. Employee eligibility for the program is normally determined by the employer after a vesting period. An employee who has reached full vesting may begin taking distributions at age 59½ without incurring a tax penalty. Withdrawals must start before the account owner becomes 72 and are taxed as regular income, whether they are made in one lump sum or over time.
Advantages of Money Purchase Plan
1) Tax advantage :
Employer and employee taxes are postponed when contributions are made to money purchase plans. Investment growth is tax-free up until retirement withdrawals. A money purchase plan's employer deduction can only be up to 25% of the income earned or paid to qualifying participants.
2) Larger account balances :
Each employee's account receives money each year as a result of the obligatory employer contribution. The contributions can accumulate into a sizable nest egg over time.
3) Steady payments :
Money buy plans are required to provide employees with a life annuity that provides a consistent value over the course of their lives, typically as a monthly payment. They can pay in other ways as well.
4) Hiring incentive :
Money purchase plans give workers the chance to save money and can be a competitive advantage when it comes to hiring. Companies that provide money purchase plans might make the perk available to both new and current employees since boosting an employee's savings through retirement contribution can help build goodwill.
5) Access to loans :
If the plan authorizes it, employees could be allowed to borrow money against the balance of their accounts.
6) Reliable retirement income :
The consistent monthly payments from a lifetime annuity might assist with budgeting and planning when employees retire and start drawing down their account.
Disadvantages of Money Purchase Plan
1) Costly to maintain :
A money buy plan's overhead and administrative expenses may be more than those of other kinds of defined contribution plans.
2) Test of top-heavy:
A plan may lose its qualified plan status and the associated tax advantages if it appears to favor those with higher incomes.
3) Necessary contributions :
The required contribution rate makes businesses responsible for payments even during lean periods, which can strain their finances.
4) Excise tax :
If businesses don't reach the minimum funding requirement, they must pay an excise tax.
5) Heavy financial burden :
A corporation could experience problems in years with weaker cash flow because contributions to a money purchase plan are compulsory (unlike the voluntary employer contributions to a 401(k) plan).
6) Inability of employees to contribute :
Employees might not be able to contribute to a plan, depending on the rules of the plan. However, individuals could still set aside a portion of their pay for retirement if their employer provides both a money purchase plan and a 401(k).
Frequently Asked Questions
What are the money purchase plan distribution rules ?
Employees often have the option of taking a lump sum or regular payments out of their plan assets. Distributions are subject to ordinary income tax. Any withdrawals made before to reaching the age of 59½ will incur a 10% early distribution penalty (unless an exception is met). In addition, required minimum distributions (RMD) apply to money purchase pension plan.
Can funds be rolled over into an IRA?
Employees who leave the company are permitted to rollover their money purchase plan funds into a 401(k), 403(b), or IRA, in line with other retirement systems.
Does vesting is allowed in money purchase plan?
Employee vesting may be mandated by employers. In this case, the workers must first put in a certain number of years of service before they can claim "ownership" of the money in their account. When employees attain the age of 59½, they can start making withdrawals after becoming fully vested. They are not now subject to a tax fine.
What is the differences between money purchase plan and profit-sharing plan ?
Employer-paid retirement contributions on behalf of employees are offered by both of these plans. The investment location is up to the employee, who can also take their vested amount with them when they quit their work. The size of the annual contribution required from employers makes a significant difference. In money purchase plans, companies are required to make a predetermined percentage of every employee's salary contribution, regardless of the company's annual revenue. Employers have more flexibility with profit-sharing plans since they can boost contributions during profitable years and decrease contributions during lean years.
Can I withdraw money from money purchase plan?
In addition to regular taxes, you must pay a penalty of 10% if you remove your money before retiring. Both the employee and your employer are prohibited from taking money out of your account. You might be permitted to borrow money from the account by your employer.
Is money purchase plan qualified?
A qualified retirement plan is a money buy pension plan. This indicates that it qualifies for tax benefits and is governed by tax laws. Similar regulations apply to all qualified retirement accounts. If you quit your job, you can transfer the funds to an IRA or 401(k).
Is it similar to a 401(k) plan?
No, it's entirely distinct. Plans with money buy only permit contributions from employers. The plan cannot be funded by pay deferrals made by employees. Employees are free to decide how to invest the funds in their account, similar to most 401(k) plans. These alternatives do differ based on what the plan's options are. Contributions grow tax-deferred and are not taxable to the employee until withdrawn, just like a 401(k).