A pension plan is a qualified plan established and maintained by an employer primarily to provide systematically for the payment of definitely determinable benefits to its employees over a period of years, usually for life, after retirement. The requirement that the benefits be “definitely determinable” may be met by providing for either fixed benefits or fixed contributions; thus, a pension plan can be either a defined benefit plan or a defined contribution plan. This article outlines two types of defined contribution plans: Profit Sharing and Money Purchase Pension plans.
A Profit Sharing plan is a qualified employer retirement plan for sharing employer profits with employees. It need not provide a definite, predetermined formula for determining the amount of profits to be shared (contribution amounts are discretionary), but there must be recurring and substantial contributions, and contributions must not be made so as to discriminate in favor of highly compensated employees
Although contribution amounts are discretionary, and are made entirely by the employer, the plan must provide a definite, predetermined formula for allocating the contributions among the participants (it need not be equal percentages of compensation), and for distributing the accumulated assets to the employees (a vesting schedule). The employer may design a vesting schedule which delays 100% ownership by the employees of their plan accounts – a kind of golden handcuffs. Vesting may be gradual (i.e., 3-7 year graded vesting) or abrupt (i.e., 100% “cliff” vesting after five years). Employees who leave before being fully vested forfeit non-vested amounts to those remaining in the plan, or reduce the amount required by the employer to contribute. Forfeitures of early-departing employees can benefit long-term employees by adding to their accounts.
Plan contributions are limited to the lesser of 25% of compensation up to a maximum compensation of $285,000 in 2020, or $57,000. The $285,000 maximum compensation amount is indexed to inflation in future years in $5,000 increments. The contribution limit will also be subject to future cost of living adjustments.
Advantages to the employer are the tax deductibility of contributions to the plan and tax deferred compounding on the investments in the account. In addition to enjoying tax-deferred growth on their plan assets, employees do not pay income taxes on the amounts contributed to the plan on their behalf in the year in which they’re made. The employer and employees can also potentially benefit from forfeitures of non-vested account balances for departing employees. Finally, and particularly if a vesting schedule is used, employers and employees benefit from the motivation provided by the plan to stay with the company. Those the employer wants to compensate most for long and loyal service are rewarded.
Profit Sharing plans may be used effectively by business owners with no employees. For both the Profit Sharing and Money Purchase Pension plans (see below), Schedule 5500 tax returns must be prepared annually (see Form 5500 filing instructions for rules affecting one-participant plans with less than $250,000 of assets, and small plans with less than 100 participants).
A Money Purchase plan is a qualified retirement plan which involves an annual, required tax deductible contribution by the employer for his or her employees. The contribution is defined as a percentage of each employee’s annual compensation, to a maximum level of 25% of compensation up to a maximum compensation of $285,000 in 2020, or $57,000. Contributions are tax deductible to the employer, accumulate tax deferred within the plan, and must be added to, or aggregated with Profit Sharing Plan contributions when determining maximum annual contribution amounts (the total of both must not exceed $57,000 in 2020 for an employee). Other aspects of Money Purchase Pension Plans are similar to those outlined for Profit Sharing Plans above.
In the past, Money Purchase Pension Plans were often used alongside Profit Sharing Plans to provide maximum benefits with the greatest flexibility. Prior to 2002, Profit Sharing Plan contributions were limited to 15% of compensation; so in order to obtain the maximum contribution amounts allowed, a Money Purchase Pension Plan with a 10% mandatory annual contribution amount would often be setup alongside of the Profit Sharing Plan in order to be able to contribute up to the 25% maximum. Now, with the changes enacted with the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA), Profit Sharing Plans are allowed to contribute up to 25% of compensation, the same as Money Purchase Pension Plans. Since Money Purchase contributions are mandatory while Profit Sharing contributions are discretionary, many firms have chosen to simplify their pension plans and increase their flexibility about whether to make contributions by offering just a Profit Sharing Plan. However, Money Purchase Pension Plans could still be utilized by employers with at least a modestly reliable business cash flow, and who want to give employees some guaranteed minimum annual pension contribution amount as part of the employment contract.
Both Money Purchase and Profit Sharing plan assets may be rolled over to an IRA, or to a subsequent employer’s plan (if permitted by the new plan) at termination of employment. Like IRA’s, assets in these plans may be withdrawn beginning at age 59 1⁄2 with no tax penalty, and must be regularly withdrawn beginning at age 72.
Some additional considerations regarding these plans:
For additional information on this or related topics, or to learn more about the investment management and financial planning services offered by B|O|S please visit our website at www.bosinvest.com.
Updated August 2020
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