How Does a Money Purchase Pension Plan Work?

Navigating the maze of retirement planning strategies can seem like an overwhelming task, especially for high-net-worth pre- and post-retirees approaching or already in their golden years. It’s a time when all financial decisions carry profound implications, and choosing the right path can feel like a high-stakes decision. 

Among the mass of retirement planning tools available, one strategy often surfaces for those seeking tax advantages, flexibility, and control over investments: the money purchase pension plan (MPPP). 

This plan, although not as widely discussed as some other retirement planning strategies, could be a game-changer in your retirement portfolio. But, as with all financial decisions for high-net-worth retirees, the question is: is it the right choice for you? Understanding how money purchase pension plans work is the first step in answering.

What is a money purchase pension?

According to the IRS, a money purchase pension plan (MPPP) is a type of defined contribution plan that requires an employer to make a set, annual contribution for each qualifying employee. This amount is typically defined by a percentage of the employee’s annual salary up to a predetermined max.

The contributions made by employers are tax-deductible, reducing the organization’s overall taxable income. For the employee, these contributions are not counted as taxable income at the time of contribution, providing immediate tax savings. Instead, taxes are paid only upon withdrawal during retirement, often at a potentially lower tax rate. 

This deferred taxation allows the investment to grow tax-free over time, accelerating the compound growth of the retirement savings. It’s important, however, to understand that early withdrawals before the age of 59 1/2 may be subjected to a 10% penalty in addition to regular income tax.

Money purchase plans vs. profit-sharing plans

A money purchase pension plan is often confused with another common retirement income planning vehicle: profit-sharing plans. Both of these plans are defined contribution plans that allow employers to contribute a set percentage of an employee’s salary each year, and both offer advantageous tax strategies for retirees. In some instances, both of these plans will be used in conjunction to offer maximum benefits to create an even more robust retirement plan.

The key difference between these two plans lies in how contributions are determined. While MPPPs have a set contribution amount, profit-sharing plans allow employers to make variable contributions each year based on company profits. This means that employees may receive different contributions each year, depending on how the company performs.

Even though the employer has the discretion to determine contribution amounts, a profit-sharing plan must establish a clear and predetermined formula for distributing these contributions and outline a vesting schedule for distributing the accumulated assets to employees.

So, how exactly does a MPPP work?

Once an employer sets up a money purchase pension plan, they must make contributions to the plan every year for each eligible employee. These contributions are typically determined by a percentage of the employee’s annual salary as long as it remains at or below the compensation limits set by the IRS — that being 25% of compensation, or $66,000 for 2023.

Let’s look at an example. If an employee earns $80,000 per year and the employer has set a contribution rate of 10%, the employer must contribute $8,000 to that employee’s retirement account for that year. This sum can then be invested in various assets, such as stocks, bonds, mutual funds, etc., based on the employee’s risk tolerance and investment preferences.

While the contributions made by an employer are immediately 100% vested, employees may have to wait for a certain period until they become fully vested in their own contributions. This means that if an employee leaves the company before becoming fully vested, they may forfeit some or all of their own contributions and any earnings on those funds.

The vesting schedule is determined by the plan and must be outlined in the plan documents. This schedule can vary, but a common vesting period is five or six years, with employees becoming fully vested after that time.

Who bears the risk in a money purchase pension plan?

With a money purchase pension plan, the risk is mainly shouldered by the employee. Since they have control over investment decisions and bear the brunt of any market fluctuations, employees must carefully consider their investment choices.*

Additionally, since contributions are fixed, employees cannot change their contribution amounts if they experience financial difficulties or need to make larger contributions for retirement planning purposes. They may still have the option to contribute to an IRA or another retirement account, subject to income limits.

On the other hand, employers and business owners also bear some risk in terms of setting a contribution rate that is sustainable for the company. If business profits decrease, it may become challenging for employers to make the required annual contributions.

*Read more about the safest investments for retirement.

Wondering how a MPPP could complement your retirement plans? Let’s talk.

A money purchase pension plan can be a valuable tool in retirement planning for high-net-worth individuals as it offers tax advantages, flexibility, and control over investments. However, it’s essential to carefully consider the risks involved and fully understand how the plan works before deciding if it’s the right choice for your retirement portfolio. 

Consulting with a financial advisor from Avidian Wealth Solutions can provide valuable insight into whether a MPPP is a strong fit for your specific financial situation and goals. We can also help you evaluate whether a MPPP would work well in conjunction with other retirement plans or strategies, such as profit-sharing plans, individual retirement accounts (IRAs), or a backdoor Roth strategy.

Schedule a conversation with us today to learn more about our services for high-net-worth retirement planning in Houston, Austin, Sugar Land, and The Woodlands.

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