In an evolving financial landscape, businesses have a host of retirement plan options at their disposal, two of which are Money Purchase and Profit Sharing plans. These Defined Contribution plans offer flexibility and specific advantages in the management of retirement benefits for employees.
Defining Money Purchase and Profit Sharing Plans
Money Purchase and Profit Sharing plans are both Defined Contribution plans. Contrary to Defined Benefit plans which specify the retirement benefit due to an employee, usually as a monthly pension payment, Defined Contribution plans focus solely on the terms of contributions made to the plan.
The key distinction lies in their contribution regulations. Money Purchase Plans, although informally referred to as pension plans, do not guarantee a specified income benefit at retirement. Instead, employers are required to contribute a predetermined percentage of each employee's compensation into separate accounts for each employee. The employees bear the investment risk, and the actual benefit they receive at retirement depends on the performance of these investments.
Profit Sharing Plans, on the other hand, allow contributions to participant accounts only when a profit is declared, providing employers with more flexibility in determining contribution amounts. However, these contributions must be made according to the guidelines set forth in the plan document.
Profit Sharing Versus Money Purchase
While both types of plans can be utilized concurrently, they are subject to an aggregate limit on employer contributions, defined as 25% of compensation or $53,000 per employee as of 2016.
A key difference is that in a Profit Sharing Plan, the company is not obligated to make contributions during non-profitable years. However, in a Money Purchase Plan, contributions are mandatory, regardless of the profit status of the company.
Both plan types offer tax advantages as contributions are not taxable until they are withdrawn during retirement.
Combining Money Purchase and Profit Sharing Plans
A distinctive feature of these plans is that they can not only be combined together but also merged with 401(k)s and other similar plans. This opens up the potential for additional employee contributions and employer matching.
Employers can match up to 6% of employee compensation without reducing the amount of contributions that they can make through profit-sharing and money-purchase arrangements. This provides a versatile and robust platform for employers to attract and retain talent through competitive retirement benefits.
Margin Trading: A Complementary Investment Strategy
Margin trading is an investment strategy that can be employed alongside retirement savings plans. In margin trading, investors use borrowed funds from a brokerage to purchase stocks, amplifying their purchasing power and potential profits. However, this method comes with higher risk as losses are also amplified.
In the context of Money Purchase and Profit Sharing plans, it's essential for employers and employees to understand that while margin trading can offer high returns, it's also associated with high risk. Therefore, it should be used cautiously, particularly in retirement plans where the primary goal is typically to provide a stable income source during retirement.
Both Money Purchase and Profit Sharing plans offer unique advantages and can be leveraged to create a comprehensive retirement benefits package. While employers must navigate contribution rules and limits, the flexibility and potential tax benefits these plans offer can make them an attractive option. Coupled with prudent investment strategies, these plans can significantly enhance the retirement readiness of employees.
Summary
Money Purchase plans and Profit Sharing plans are two types of Defined Contribution plans that can be used at a business, together if desired. Both of these are Defined Contribution plans, which means that only the terms of the contributions to the plan are defined in the plan document.
This is different than Defined Benefit plans, which specifically define the benefit due to an employee at retirement, which is generally a monthly pension payment. If an employer wants to use both a Money Purchase plan and a Profit Sharing plan, it is possible, but since both of them are Defined Contribution plans, they will be limited in aggregate to the allowable defined contribution limits for employer contributions.
To learn more information about the differences, see”What’s the Difference between a Defined Benefit Plan and a Defined Contribution Plan?”
In 2016, this is defined as 25% of compensation up to $53,000 per employee. Money Purchase Plans are called pension plans as well, but they do not define the income benefit due at retirement. In these plans, employers are obligated to pay a set percentage of each employee’s compensation, but the assets are in a separate account for each employee, and each employee bears the investment risk.
So the term “pension” is used very loosely here, because there is no sure payment of income at retirement, unless the participants are funding annuity contracts with guarantees. Profit Sharing Plans only have to pay into participant accounts when a profit is declared. In a money-purchase plan, on the other hand, contributions must be made even in years without a profit.
Profit sharing plans give employers more flexibility in determining how much of the profits will be contributed to the account. They will still need to adhere to whatever standards they have set forth in their plan document. Contributions to both plans are not taxable until they are withdrawn in retirement.
Money purchase and Profit-Sharing plans can not only be combined together, but can also be combined in 401(k)s and other plans that may have more room for employee contributions and employer matching. Up to 6% of employee compensation can be contributed in the form of a match without decreasing the amount of contributions an employer can make through profit-sharing and money-purchase arrangements.
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