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Profit-sharing and money purchase pension plans are among those plans available for business owners and their employees.
These are defined contribution plans originally established in 1962 with the Self-Employed Individuals Tax Retirement Act, introduced by Eugene Keogh, thus the name they are mostly known by, Keogh plans. The plans were changed by the 2001 Economic Growth and Tax Relief Reconciliation Act and subsequent legislation. They've changed so much that the Internal Revenue Code no longer refers to them as Keoghs, they are now known as HR 10s or qualified plans.
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A defined contribution plan provides an individual account for each participant in the plan. It provides benefits to a participant largely based on the amount contributed to that participant's account. Benefits are also affected by any income, expenses, gains, losses, and forfeitures of other accounts that may be allocated to an account.
Both profit-sharing and money purchase plans are similar to 401(k) plans, but they are more suitable for smaller businesses or highly paid professionals (such as self- employed dentists or lawyers) who look for similar benefits and tax advantages as those who work in more traditional, corporate settings.
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Although it is called a "profit-sharing plan," you don't actually have to make a business profit for the year in order to make a contribution (except for yourself if you are self-employed).
A profit-sharing plan accepts discretionary employer contributions. There is no set amount that the law requires you to contribute. If you can afford to make some amount of contributions to the plan for a particular year, you can do so. Other years, you do not need to make contributions.
If you do make contributions, you will need to have a set formula for determining how the contributions are divided. This money goes into a separate account for each employee.
The most common way for a business to determine the allocation of a profit-sharing plan is through the comp-to-comp method. Using this calculation, an employer first calculates the sum total of all of its employees’ compensation. Then, to determine what percentage of the profit-sharing plan an employee is entitled to, the company divides each employee’s annual compensation by that total. To arrive at the amount due the employee, that percentage is multiplied by the amount of total profits being shared.
If you establish a profit-sharing plan, you:
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As with 401(k) plans, you can make a profit-sharing plan as simple or as complex as you want. You may purchase a pre-approved profit-sharing plan document from a benefits professional or financial institution to cut down on administrative headaches.
Here are the main advantages and disadvantages of profit-sharing plans.
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- Flexible contributions – contributions are strictly discretionary;
- Good plan if cash flow is an issue;
- Administrative costs may be higher than under more basic arrangements (SEP or SIMPLE IRA plans);
- Need to test that benefits do not discriminate in favor of the highly compensated employees.
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Only employer contributions are allowed. If a salary deferral feature is added to a profit-sharing plan, it is a "401(k) plan."
The Money Purchase Pension Plan
With a money purchase plan, the plan states the contribution percentage that is required. This type of arrangement is different than a profit-sharing plan where the employer decides to contribute a certain amount,
For example, if your money purchase plan has a contribution of 5% of each eligible employee’s pay, you, as the employer, need to make a contribution of 5% of each eligible employee’s pay to their separate account.
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The amount in each money-purchase plan member's account differs, depending on the employee's level of contributions and the investment return earned on those contributions.
A participant’s benefit is based on the amount of contributions to their account and the gains or losses associated with the account at the time of retirement.
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Employers typically establish a vesting period after which an employee is eligible for the program. After being fully vested, an employee may start taking out funds at age 591⁄2 without a tax penalty.
In past years, money purchase plans had higher deductible limits than profit- sharing plans. This is no longer the case.
As with profit-sharing plans, if you establish a money purchase plan, you can have other retirement plans, can be a business of any size, and need to annually file a Form 5500. Money purchase plans can be used in addition to profit-sharing plans to maximize annual savings levels.
You can make a money purchase plan as simple or as complex as you want. Pre- approved money purchase plans are available to cut down on administrative headaches.
Pros and cons of money purchase plans include:
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- Possibility to grow larger account balances than under some other arrangements.
- Administrative costs may be higher than under more basic arrangements.
- Need to test that benefits do not discriminate in favor of the highly compensated employees.
- An excise tax applies if the minimum contribution requirement is not satisfied.
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Employer and/or employee contributions are allowed.
Contribution limits for both plans are set at the lesser of 25% of compensation or $56,000 (for 2019; $55,000 for 2018, subject to cost-of-living adjustments for later years).
Annual filing of a Form 5500-series return/report is required for both plans.
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The IRS, Department of Labor, and Pension Benefit Guaranty Corporation jointly developed the Form 5500-series returns for employee benefit plans to satisfy annual reporting requirements under ERISA and the Internal Revenue Code. You can find more details on the IRS webpage Form 5500 Corner.
Amounts paid to plan participants from a qualified plan are called distributions. Distributions may be nonperiodic, such as lump-sum distributions, or periodic, such as annuity payments. Also, certain loans may be treated as distributions.
A qualified plan must provide that each participant will either:
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- Receive his or her entire interest (benefits) in the plan by the required beginning date, or
- Begin receiving regular periodic distributions by the required beginning date in annual amounts figured to distribute the participant's entire interest (benefits) over his or her life expectancy or over the joint life expectancy of the participant and the designated beneficiary (or over a shorter period).
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These distribution rules apply individually to each qualified plan. You cannot satisfy the requirement for one plan by taking a distribution from another. The plan must provide that these rules override any inconsistent distribution options previously offered.
If the account balance of a qualified plan participant is to be distributed (other than as an annuity), the plan administrator must figure the minimum amount required to be distributed each distribution calendar year. This minimum is figured by dividing the account balance by the applicable life expectancy. The plan administrator can use the life expectancy tables in Pub. 590-B for this purpose.
You can usually deduct, subject to limits, contributions you make to a qualified plan, including those made for your own retirement. The contributions (and earnings and gains on them) are generally tax free until distributed by the plan.
The deduction for contributions to a defined contribution plan (profit-sharing plan or money purchase pension plan) cannot be more than 25% of the compensation paid (or accrued) during the year to your eligible employees participating in the plan. If you are self-employed, you must reduce this limit in figuring the deduction for contributions you make for your own account.
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When figuring the deduction limit, the maximum compensation that can be taken into account for each employee in 2019 is $280,000 ($275,000 in 2018).
Check out Publication 560, Retirement Plans for Small Business, if you want to find out more details about these plans. More importantly, keep up with our newsletters to see what other kinds of pension plans are out there and for regular updates on topics of general interest.
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