Chapter 16: money purchase pension plan.
A money purchase plan is a qualified employer retirement plan that is, in many ways, the simplest of all qualified plans:
* Each employee has an individual account in the plan. The employer makes annual contributions to each employee's account under a nondiscriminatory contribution formula. Usually the formula requires a contribution of a specified percentage (up to 25%) of each employee's annual compensation. Annual contributions to the employee's account generally cannot be more than $49,000 (in 2009, as indexed).
* Plan benefits consist of the amount accumulated in each participant's account at retirement or termination of employment. This is the total of employer contributions, interest or other investment return on plan assets, and capital gains realized by the plan on sales of assets in the employee's account.
* The plan may provide that the employee's account balance is payable in one or more forms of annuities equivalent in value to the account balance.
WHEN IS IT INDICATED?
1. When an employer wants to install a qualified retirement plan that is simple to administer and explain to employees.
2. When employees are relatively young and have substantial time to accumulate retirement savings.
3. When employees are willing to accept a degree of investment risk in their plan accounts, in return for the potential benefits of good investment results.
4. When some degree of retirement income security in the plan is desired. (While accounts are not guaranteed, annual employer contributions are required. This provides a degree of retirement security that is intermediate between a defined benefit plan and a profit sharing plan.)
5. When an employer seeks to reward long-term employee relationships.
1. As with all qualified plans, a money purchase plan provides a tax-deferred retirement savings medium for employees.
2. The plan is relatively simple and inexpensive to design, administer, and explain to employees.
3. The plan formula can provide a deductible annual employer contribution of up to the lesser of (a) 100% of the employee's compensation or (b) $49,000 (in 2009). However, the employee's deduction is limited to 25% of covered payroll. Therefore, a money purchase plan typically provides a formula of up to 25% of each employee's compensation, with the contribution not exceeding $49,000. (1)
4. Individual participant accounts allow participants to benefit from good investment results in the plan fund.
1. Retirement benefits may be inadequate for employees who enter the plan at older ages. For example, if an employer contributes 10% of compensation annually to each employee's account, the accumulation at age 65 for employees with varying entry ages will be as follows, assuming the plan fund earns an average return of 9%:
Age at plan Annual Account balance entry compensation at age 65 25 $35,000 $1,289,022 30 35,000 822,937 40 35,000 323,134 50 35,000 112,012 55 35,000 57,961 60 35,000 22,832
This illustration shows that the "time factor" works rapidly to increase account balances. If a closely held corporation that has been in business for many years adopts a money purchase plan, key employees often will be among the older plan entrants. The money purchase plan's failure to provide adequately for such employees, even with their high compensation levels, can be a serious disadvantage.
[FIGURE 16.1 OMITTED]
However, this is not the whole story--there's another factor in realistic situations that reduces the apparent disparity between long-service and short-service employees. Because salaries increase over time, the long service/short service disparity in the annual pension from a money-purchase plan-as a percentage of final average compensation--is much less than if salaries do not increase. Figure 16.1 shows that, if all salaries increase at 7% annually, a 15-year employee receives a pension of 19% of final average salary while the 35-year employee gets 48% of final average salary. This is much less than the disparity resulting if salaries increase at only 3% annually, or do not increase at all. In short, in actual practice a money purchase plan may not be as disadvantageous to shorter service employees as might appear.
[FIGURE 16.2 OMITTED]
2. The annual addition to each employee's account in a money purchase plan is limited to the lesser of (a) $49,000 (in 2009, as indexed), or (b) 100% of compensation. (2) This, plus the $245,000 cap on compensation (in 2009, as indexed), limits the relative amount of funding available for highly compensated employees. For example, if an employee earns $300,000 in 2009, no more than $49,000 annually can be contributed for that employee; but that $49,000 is only 20% of the $245,000 of the employee's compensation that is allowed to be taken into account.
3. Employees bear investment risk under the plan. The ultimate amount that can be accumulated under a money purchase plan is very sensitive to investment return, even for an employee who entered the plan at an early age. Figure 16.2 shows this by comparing the ultimate account balance resulting from $1,000 of annual contribution at two different return rates.
While bearing investment risk is a potential disadvantage to employees, it does tend to reduce employer costs as compared with a defined benefit plan.
4. The plan is subject to the Internal Revenue Code's minimum funding requirements. Employers are obligated to make the plan contribution each year or be subject to minimum funding penalties. Under current law, a qualified profit sharing plan (see Chapter 17) permits the same level of deduction to the employer (i.e., 25% of payroll) as a money purchase plan, but without the requirement of mandated minimum annual contributions.
Most money purchase plans use a benefit formula requiring an employer contribution that is a flat percentage of each employee's compensation. Percentages up to 25% may be used. Only the first $245,000 (in 2009, as indexed) of each employee's compensation can be taken into account in the plan formula. (3)
Some money purchase formulas also use a factor related to the employee's service. Service-related factors generally favor owners and key employees. In small, closely held businesses or professional corporations, the use of a service-related factor might result in prohibited discrimination in favor of highly compensated employees. Plan designers generally avoid service-related contribution formulas in these situations.
Nondiscrimination regulations under IRC Section 401(a)(4) provide safe harbors for money purchase plans with uniform allocation formulas; alternative methods for satisfying nondiscrimination requirements include satisfying a general nondiscrimination test, restructuring, or cross-testing (testing defined contribution plans on the basis of benefits see Chapter 21). (4)
A plan benefit formula can be "integrated" with Social Security (integration is also referred to as "permitted disparity"). This avoids duplicating Social Security benefits already provided to the employee and reduces employer costs for the plan. An integrated formula defines a level of compensation known as the "integration level." The plan then provides a higher rate of employer contributions for compensation above the integration level than the rate for compensation below the integration level.
Example: A money purchase plan specifies an integration level of $20,000 and provides for employer contributions of 14% of compensation above the $20,000 integration level and 10% below the $20,000 integration level. Employee Art Rambo earns $30,000 this year. The employer contribution to Art's account this year totals $3,400--14% of $10,000 (Art's compensation in excess of the $20,000 integration level) plus 10% of the first $20,000 of Art's compensation.
The Internal Revenue Code and regulations specify the degree of integration permitted in a plan. These rules are discussed further in Chapter 7.
Any of the Code's permitted vesting provisions can be used in a money purchase plan. Since money purchase plans tend to be oriented toward longer service employees, the 3-year "cliff vesting" provision (that is, no vesting until three years of service, then 100% vesting) is often used.
If an employee leaves before becoming fully vested in his or her account balance, an unvested amount referred to as a "forfeiture" is left behind in the plan. Forfeitures can be used either to reduce future employer contributions under the plan or they can be added to remaining participants' account balances. Adding forfeitures to participants' account balances tends to be favorable to key employees, since they are likely to participate in the plan over a long time period. For this reason, the IRS requires forfeitures to be allocated in a nondiscriminatory manner. This usually requires forfeiture allocation in proportion to participants' compensation, rather than in proportion to their existing account balances.
Benefits in a money purchase plan are usually payable at termination of employment or at the plan's stated normal retirement age. Money purchase plans traditionally provide that the participant's account balance is converted to an equivalent annuity at retirement, based on annuity rates provided in the plan. This is the origin of the term "money purchase." It has become more common to provide for a lump sum or installment payment from the plan as an alternative to an annuity. However, a money purchase plan, as a condition of qualification, must provide a joint and survivor annuity as the automatic form of benefit. The participant, with the consent of the spouse, may elect a different benefit option. This is discussed further in Chapter 8.
The IRS generally does not allow money purchase plans to provide for "in-service distributions"--that is, benefits payable before termination of employment. Distributions of employer contributions or earnings from pension plans are not permitted prior to death, retirement, disability, severance of employment or termination of the plan.5 However, plan loan provisions are allowable, although relatively uncommon.
Money purchase plan funds are generally invested in a pooled account managed (through a trustee or insurance company) by the employer or a fund manager designated by the employer. Either a trust fund or group or individual insurance contracts can be used. Chapter 13 discusses how life insurance can be used in the plan.
1. Employer contributions to the plan are deductible when made, so long as the plan remains "qualified." (6) A plan is qualified if it meets eligibility, vesting, funding and other requirements discussed in Chapter 7. In addition, the plan must designate that it is a money purchase pension plan. (7) The deduction is limited to 25% of total payroll of the employees covered under the plan. (8)
2. Assuming the plan remains qualified, taxation of the employee on plan contributions is deferred. Both employer contributions and earnings on plan assets are nontaxable to plan participants until withdrawn. (9)
3. Under IRC Section 415, annual additions to each participant's account are limited to the lesser of (a) 100% of the participant's compensation, or (b) $49,000 (in 2009, as indexed). (100 Annual additions include: (1) employer contributions to the participant's account; (2) forfeitures from other participants' accounts; and (3) employee contributions to the account. (11)
4. Distributions from the plan must follow the rules for qualified plan distributions. Certain premature distributions are subject to penalties. The distribution rules are discussed in Chapter 8.
5. Lump sum distributions made after age 591/2 may be eligible for a special 10-year averaging tax computation (available to certain employees born before 1936) that may reduce tax rates on the benefit. Not all distributions are eligible for these calculations. Chapter 8 covers these rules.
6. The plan is subject to the minimum funding rules of the Code. (12) This requires minimum annual contributions, subject to a penalty imposed on the employer if less than the minimum amount is contributed. (13) For a money purchase plan, the minimum contribution is generally the amount required under the plan's contribution formula. For example, if the plan formula requires a contribution of 20% of each participant's compensation, this is generally the amount required to meet the minimum funding rules. Chapter 7 discusses these rules further.
7. Certain employers adopting a new plan may be eligible for a business tax credit of up to $500 for "qualified startup costs." See Chapter 10 for details.
8. A plan may permit employees to make voluntary contributions to a "deemed IRA" established under the plan. Amounts so contributed reduce the limit for other traditional or Roth IRA contributions. See Chapter 5 and Chapter 6 for details.
9. The plan is subject to the ERISA reporting and disclosure rules outlined in Appendix E.
1. Target benefit plans are much like money purchase plans, but the employer contribution percentage can be based on age at plan entry--higher for older entrants. Such a plan may be more favorable where the employer wants to provide adequate benefits for older employees.
2. Profit sharing plans provide more employer flexibility in contributions but less security for participants. The limit on deductible contributions to a profit sharing plan is 25% of payroll.
3. Defined benefit plans provide more security of retirement benefits and proportionately greater contributions for older plan entrants, but are much more complex to design and administer.
4. Nonqualified deferred compensation plans can be provided exclusively for selected executives, but the employer's tax deduction is generally deferred until benefit payments are made. This can be as much as 20 or 30 years after the employer's contribution is made.
5. Individual retirement saving is available as an alternative or supplement to an employer plan, but except for certain IRAs, there is no tax deferral.
See also the discussion in Chapter 1, "Designing the Right Pension Plan."
HOW TO INSTALL A PLAN
Installation of a money purchase plan follows the qualified plan installation procedure described in Chapter 10.
WHERE CAN I FIND OUT MORE ABOUT IT?
Graduate Course: Qualified Retirement Plan (GS 814), The American College, Bryn Mawr, PA.
QUESTIONS AND ANSWERS
Question--Can a self-employed person adopt a money purchase plan?
Answer--A self-employed person can adopt a money purchase plan covering not only his or her regular employees, if any, but also covering the self-employed person(s). Such plans are sometimes referred to as "Keogh" or "HR 10" plans. The self-employed person is treated much the same as the regular employees covered, but there are some special rules and planning considerations that are covered in Chapter 22 of this book.
Question--What special issues are involved in money purchase plans covering shareholder-employees in an S corporation?
Answer--S corporations can have money purchase plans that cover shareholder-employees as well as regular employees. However, the plan contribution formula generally cannot provide an employer contribution for all of the shareholder-employee's income from the corporation. The employer contribution formula can be based only on the shareholder's compensation for services rendered to the corporation. Any portion of the shareholder's income that represents dividends must be excluded from the plan formula.
Question--Can an employer fund a money purchase plan using employee salary reductions?
Answer--Salary reductions by employees allowing employee contributions on a before-tax basis are allowed only in (1) a profit sharing (Section 401(k) type) plan, (2) a salary reduction SEP (simplified employee pension), which had to be adopted before 1997--see Chapter 24, (3) a SIMPLE IRA, see Chapter 23, or (4) a Section 403(b) tax deferred annuity plan (tax-exempt employers only). Thus, this kind of funding for a money purchase plan is not available except for a plan "grandfathered" under pre-1974 law.
However, money purchase plans can allow after-tax contributions by employees to increase account balances (permitting greater tax-sheltered investment accumulation) and ultimate retirement benefits. Such after-tax contribution provisions must meet the administratively complex nondiscrimination rules of Code section 401(m). (These are discussed in Chapter 19.) As a result of these rules, after-tax contribution provisions in money purchase plans are uncommon.
(1.) The employer's deduction to a money purchase pension plan cannot exceed the Section 415 annual additions limit for a defined contribution plan. IRC Section 404(j)(1). For years beginning in 2009, this 415 limit is the lesser of (a) $49,000, or (b) 100% of compensation. IRC Section 415(c).
(2.) IRC Sec. 415(c).
(3.) IRC Section 401(a)(17).
(4.) See Treas. Reg. [section]1.401(a)(4)-2.
(5.) See Rev. Rul. 69-277, 1969-1 CB 116; Rev. Rul. 74-417, 1974-2 CB 131. If money purchase plan assets are "spun-off" to a profit sharing plan, the accounts in the new plan must retain the money purchase restrictions on in-service distributions. However, if the money purchase accounts are "rolled over" to a profit sharing plan (i.e., distributed to participants who then recontribute them to the successor plan), the money purchase plan in-service restrictions no longer apply. Rev. Rul. 94-76, 1994-2 CB 46.
(6.) IRC Section 404(a).
(7.) IRC Section 401(a)(27)(B).
(8.) IRC Section 404(a)(3)(A)(v).
(9.) IRC Section 402(a).
(10.) See IRC Sec. 415(c); Notice 2008-102, 2008-45 IRB 1106.
(11.) IRC Section 415(c)(2).
(12.) IRC Sections 412(a), 412(h); 430.
(13.) IRC Section 4971.
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|Title Annotation:||Defined Contribution Plans|
|Publication:||Tools & Techniques of Employee Benefit and Retirement Planning, 11th ed.|
|Date:||Jan 1, 2009|
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