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Profit Sharing & Money Purchase Pension Plans

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.

Profit Sharing Plan

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 $230,000 in 2008, or $46,000. The $230,000 maximum compensation amount is indexed to inflation in future years in $5000 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 after the $100,000 asset level has been reached (simplified requirements may apply for plans with 25 or fewer participants).

Money Purchase Pension Plan

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 $230,000 in 2008, or $46,000. 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 $46,000 in 2008 for an employee). Other aspects of Money Purchase Pension Plans are similar to those outlined for Profit Sharing Plans above.

 

Combination Plans

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 70 1⁄2.

Some additional considerations regarding these plans:

 

  • Unlike Simple or SEP IRA’s, Profit Sharing and Money Purchase Pension plans may allow borrowing against individual accounts.
  • Profit Sharing and Money Purchase Pension plans for business owners with no, or few, employees are administratively straight forward. Often the accountant can track vesting for a small number of employees and file the 5500’s. Annual account summaries for each employee are also often prepared by the accountant for small plans.
  • For larger employee groups, a plan administrator should be involved.
  • Establishing smaller plans can easily be accomplished using brokerage prototype forms.

For additional information on this or related topics, or to learn more about the investment management and financial planning services offered by Bingham, Osborn & Scarborough, LLC, please visit our website at www.bosinvest.com.

Disclosure:

This white paper is for informational purposes only and is not intended to be used as a general guide to investing or financial planning, or as a source of any specific recommendations, and makes no implied or express recommendations concerning the manner in which any individual’s account should or would be handled, as appropriate strategies depend upon the individual’s objectives. It is the responsibility of any person or persons in possession of this material to inform himself or herself of, and to seek appropriate advice regarding, any investment or financial planning decisions, legal requirements, and taxation regulations which might be relevant to the topic of this white paper or the subscription, purchase, holding, exchange, redemption or disposal of any investments.

The portfolio risk management process includes an effort to monitor and manage risk, but does not imply low risk. Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed, and a loss of principal may occur.

This white paper does not constitute a solicitation in any jurisdiction in which such a solicitation is unlawful or to any person to whom it is unlawful. Moreover, this white paper neither constitutes an offer to enter into an investment agreement with the recipient of this document nor an invitation to respond to the document by making an offer to enter into an investment agreement.

Opinions expressed are current opinions as of the date appearing in this material only and are subject to change. No part of this material may, without the prior written consent of Bingham, Osborn & Scarborough, LLC, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.

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