Employees covered by company retirement plans are familiar with defined-contribution plans like 401(k), 403(b) or SEP-IRA accounts. A money purchase plan is another such employer-sponsored plan that can help you save for retirement. It is similar to these other accounts, except that the contributions are typically made by the company instead of the employee. In this article, we’ll define what these plans are, how they work and annual contribution limits. Consider working with a financial advisor to make sure you’re taking full advantage of employer-sponsored opportunities.
What Is a Money Purchase Plan?
A money purchase plan is an employer-sponsored retirement account that contributes a specific percentage of each employee’s annual salary. Employers make annual contributions to each employee’s account no matter how the company performs. Money purchase plans are defined contribution plans, similar to a 401(k) or 403(b).
The annual contributions by the employer are defined by the money purchase plan documents. For example, if the plan documents say 5% then each employee will receive 5% of his or her salary into a separate account within the plan. For an employee with $60,000 in salary, the contribution on their behalf would be $3,000. If the company fails to make the required contributions, then it owes excise taxes on the amount not contributed.
How Do Money Purchase Plans Work?
While money purchase plans are similar to more commonly used company retirement plans, they do have unique features that set them apart from the others. Here are the features that make money purchase plans work:
- Contributions are made by the employer. Contributions are typically made by the company rather than the employee. Some plans allow employee contributions. When that happens, employees may be required to contribute.
- Top-heavy testing requirements. To ensure that the plan does not disproportionately benefit highly compensated employees, the plan must not be “top-heavy.” If the owners and highly compensated employees own more than 60% of the plan’s assets, it might lose its qualified plan status. This could result in significant tax penalties for the employer and employees who participate in the plan.
- Employees choose investments. Although contributions are mostly made by the company, employees own their individual accounts. As owners of their accounts, employees choose how to invest among the available options within the plan.
- Annual contributions percentages do not change. While some companies may adjust profit sharing or 401(k) matching contributions based on their annual performance, a money purchase plan does not have that kind of flexibility.
- Vesting schedules may apply. A vesting schedule reduces risk to the employer by requiring employees to work for a certain number of years before they are fully vested in the account.
- Investments grow tax-deferred. Investment returns grow tax-deferred each year, similar to an IRA or 401(k). When the money is withdrawn, the employee pays ordinary income taxes on distributions.
- Can roll over the account when leaving the job. Similar to other employer-sponsored retirement plans, employees can roll over their vested balance to a 401(k) or an IRA when they leave the job.
- The employer may offer additional retirement plans. Because money purchase plans operate similarly to a profit-sharing plan, the company may offer other retirement accounts for employees to contribute to, such as a 401(k), 403(b) or 457 plan.
What Is the Money Purchase Plan Limit?
Like most retirement plans, money purchase plans have limits on how much can be contributed each year. With money purchase plans, an employer can contribute up to 25% of an employee’s salary, with a cap of $58,000 for 2021. The annual maximum is subject to cost-of-living adjustments, so the cap will most likely increase each year. Because of the high annual contribution limits, money purchase plan balances may grow much faster than other retirement accounts with lower limits.
Employers may offer other employer-sponsored retirement plans in addition to the money purchase plan. For a worker with a money purchase plan and a 401(k), up to $77,500 could be contributed to their employer-sponsored retirement accounts each year. That would be $58,000 from the employer-paid money purchase plan plus individual 401(k) contributions of $19,500 withheld from their paycheck. If they are eligible, the employee could also contribute another $6,000 to a traditional or Roth IRA.
Here are the current annual contribution limits in 2021 for several popular retirement accounts.
Retirement Plan with 2021 Annual Contribution Limits*
|Traditional or Roth IRA||$6,000|
|Money Purchase Plan||$58,000|
*Contribution limits may be higher in some plans based on an employee’s age.
Money Purchase Plans vs. Profit-Sharing Plans
Both of these plans offer employer-paid retirement contributions on behalf of employees. They have the same annual contribution limits (25% of salary and $58,000 in 2021) and the money grows tax-deferred within the account. Employees can choose where the money is invested and take the vested balance with them when they leave the job.
The big difference is how much employers are required to contribute each year. With money purchase plans, employers must contribute a set percentage of every employee’s salary, regardless of how much or how little it made that year. Profit-sharing plans offer a greater degree of flexibility, so employers can reduce the contribution in lean years and increase contributions when profits are high. Because of this flexibility, profit-sharing plans are becoming more popular.
The Bottom Line
Money purchase plans offer an additional way to compensate employees with consistent retirement contributions each year. These plans are popular with employees because the employer usually makes all of the contributions and the contributions are mandatory, even when the company has poor financial results. However, many employers choose profit-sharing plans instead because the annual contribution amount is discretionary and the reporting requirements are similar.
Tips on Investing
- According to industry experts, people who work with a financial advisor are twice as likely to be on track to meet their retirement goals. Finding one doesn’t have to be hard. SmartAsset’s matching tool can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to up to three registered investment advisors who suit your needs, all vetted and free of disclosures. If you’re ready, get started now.
- Don’t forget about Social Security. You’ll get a check from the government each month, which can help you get to your desired retirement income level. Find out how much you’ll get with our free Social Security calculator.
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