A money purchase plan is a type of defined contribution plan where employers contribute a set percentage of employees’ annual salaries for retirement purposes. Like other retirement plans, the money grows tax-deferred and there is a penalty for withdrawing the funds prior to retirement age. Not all money purchase plans allow employees to contribute money, but if they do, employee contributions may be mandatory.
When contemplating a new job, workers need to take a lot into account when choosing between multiple offers, aside from a regular salary. For example, in addition to the workload of the position, potential employees may also consider opportunities for promotions, regular raises, and the company culture, among other things.
Another consideration for potential employees is the benefits package, including retirement planning options. A money purchase pension plan is one of several possibilities you might be offered. With all things otherwise being equal, this might be an attractive option for you — especially if it’s offered in conjunction with another qualified retirement plan, such as a 401(k).
How money purchase plans work
Money purchase plans are defined contribution plans that come with required contributions. This means your employer must annually deposit a certain percentage of your salary into your account. Depending on the plan, employees may not be allowed to contribute as well, or they may be required to contribute.
In 2022, the annual limits are the lesser of 25% of the employee’s salary or $61,000 per employee — the plan determines how big of a percentage you will receive.
A money purchase plan is a qualified retirement plan, and like other defined contribution plans, the money is tax-deferred for the employee and tax-deductible for the employer. For the employee, this means you’re not taxed on that income until after you’re retired and start withdrawing the funds. For the employer, that means a tax break for money provided to employees.
Typically upon retirement, money purchase plans are distributed as annuity payments for the lifetime of the plan participant. However, if you prefer, you can opt to receive your benefits in a lump sum or periodic payments.
How does this differ from a profit-sharing plan?
This differs from profit-sharing plans in that profit-sharing plan amounts can vary depending on how well the company did that year. In that scenario, you will either get more or less per year based upon the profitability of the firm.
That’s not the case with a money purchase plan, where the percentage is consistent. For example, with a money purchase pension plan, an employer may be obligated to annually deposit 5% of the salary into an employee’s account for retirement planning. That 5% is fixed, so as the salary increases, the total amount deposited will grow as well.
How a money purchase plan differs from a 401(k)
While a money purchase pension plan is no longer as common as retirement plans such as 401(k) and 403 (b), there are some similarities. For one thing, often both the employer and employee can make annual contributions.
The difference with the 401(k) is that the employer contributions are frequently not required, whereas obligatory employer contributions are the whole premise of the money purchase plan.
Do employers match funds with 401(k) plans?
With a 401(k), many employers will often “match” employee contributions, but only up to a certain amount. For example, they may cap annual employer contribution limits at 3% to 5% of a worker’s salary.
Other companies may offer a 401(k), but do not add to the employee benefit plan. While 403(b) retirement plans are much like 401(k) plans, they are only offered by nonprofit organizations and are less likely to have matching employer contributions.
|Money Purchase Plan||401 (k)|
|• Require employer contributions||• Do not require employer contributions|
|• Money grows tax-deferred||• Money grows tax-deferred|
|• Employee contributions might be required||• Employee contributions not required|
|• Penalties for early withdrawal||• Penalties for early withdrawal|
|• Annual limits: $61,000||• Annual limits: $61,000|
Pros and cons of a money purchase plan
A money purchase plan could be a great addition to your company, whether it’s a startup or a corporate giant. However, there are some downsides to consider before setting up this form of retirement plan.
Here is a list of the benefits and the drawbacks to consider.
- Hiring incentives for workers and employers. The primary benefit of a money purchase plan is that employer contributions are required, unlike other plans. This can make a job offer more attractive to a potential employee because they know they’ll be getting a guaranteed investment into their retirement savings plan. This also provides employers with a stronger bargaining position to attract top talent in their industry.
- Larger account balances for employees. Many firms that offer money purchase plans will also provide a 401(k) retirement plan as well. This gives plan participants the ability to maximize their employee contributions, making their total annual input into qualified retirement plans that much larger.
- Tax benefits for employers and employees. Not only are money purchase plan funds tax-deferred for employees, but employers also receive tax deductions on their contributions. This can make a huge difference for smaller companies.
- Consistent contribution percentages. Regardless of how the company performs, the employee will receive the same contribution to their plan every year. This could be a huge plus for many employees worried about the day-to-day performance of a company.
- Higher administrative costs for employers. Can make money purchase plans more expensive for employers than other defined contribution plans.
- Possible tax penalties. Employers also need to be careful not to discriminate in favor of highly compensated employees, over those with smaller salaries. If the company doesn’t meet minimum contribution requirements, it could lose its qualified plan status and may be subject to an excise tax.
- Fixed required payments. The main disadvantage of money purchase plans is for the employer. Because a money purchase pension requires a deposit of a specific percentage of employee salary, a firm can’t alter that contribution based on how the company performs.
- Employee contributions may de-incentivize certain employees. Though not all money purchase plans require employee contributions, those that do may be in a tougher position. While guaranteed employer contributions are enticing, required employee contributions may turn some people away.
Because money purchase plans are qualified retirement plans, they must meet certain code requirements by the Internal Revenue Service (IRS). These include both tax benefits, as well as tax regulations, for both employer and employee.
- Retirement plans enjoy tax-deferred growth
- After an employee is fully vested, they may leave the company and roll their retirement money into a 401(k) or IRA
- Employers can authorize loans, but not withdrawals, from the retirement plan
- There can be a tax penalty for withdrawing money from your account prior to retirement
What are vesting schedules?
Most firms that offer retirement plans will usually require a vesting schedule. This means an employee can’t just work for one or two years and then leave with the contribution amounts from the employer (your own contributions are yours from day one).
To be fully vested usually takes about five years, give or take, at which point employer contributions are 100% yours to roll into a 401(k) or IRA should you leave the company.
Are 401(k) and 403(b) plans the same thing?
These days, the more common retirement benefits offered by employers are likely to be either a 401(k) by for-profit firms or a 403(b) if you accept a position with a nonprofit. The main reason is these plans don’t require employers to contribute a monthly benefit, making them less costly for employers.
Other than the different types of companies that make these plans available to employees, they are very similar. However, because 403(b) benefits are provided by nonprofit organizations, there is less likelihood of employer contributions for obvious reasons.
What does an annuity plan mean?
If you opt for an annuity plan, you will receive a fixed amount of money each year for the rest of your life. This can be handy if you are concerned that your retirement accounts won’t be enough to see you through your lifetime.
However, if you die, at least some of that money may not be eligible to pass on to your beneficiaries. That’s one of the reasons why many retirees may choose to take lump sum payments, as needed or required.
- A money purchase plan is a type of defined contribution plan that requires employers to annually contribute a set percentage of money into employees’ retirement accounts.
- A money purchase plan is similar to a profit-sharing plan, except employer contributions don’t vary based on the profitability of the company.
- Sometimes money purchase plans offer you the best opportunity to accumulate more money than simpler defined contribution plans, such as a 401(k).
- There are significant tax penalties and fees if you withdraw money from your retirement savings plan prior to retirement age.
View Article Sources
- Retirement Topics – Contributions — IRS
- Choosing a Retirement Plan: Money Purchase Plan — IRS
- 403(b) vs. 401(k): What’s the Difference? — SuperMoney
- What is a Tax-Free Retirement Account (TFRA)? — SuperMoney
- How Does Your 401(k) Plan Measure Up? — SuperMoney
- Ultimate Guide to 401(k) Withdrawals — SuperMoney
- The Complete Guide to 401k Plans — SuperMoney
- Ultimate Retirement Guide — SuperMoney
- How To Manage Your Personal Finances Successfully — SuperMoney
- How Much Money Should You Save From Your Salary to Be a Millionaire? — SuperMoney