Pension vs 401(k)

What Is a Pension Plan? 

A pension plan is a defined benefit plan sponsored by your employer. Depending on where you live, a “defined benefit” is an award from an employer that promises a specific amount of money at or after retirement.

The exact payout amount depends on many factors, including how long the employee worked for the company and how much they earn per year over their career.

With a pension, your income doesn’t change after you retire.

In a pension scheme, the employee receives an entitlement to a future benefit on retirement, termination of employment, or death.

Usually, this type is very expensive for employers since they need to cover retirees’ living costs for years into the future. This is why some companies have been switching from pensions to defined contribution plans, such as 401(k)s.

Pros and Cons of a Pension Plan

There are several benefits to having a pension plan, especially if you have the option at your current job.

Guaranteed Benefits

It’s set in stone so there are no surprise changes or reductions later on down the road. You’ll know exactly how much your retirement income will be when you’re eligible to take it.

Though this protection also means that it is very restrictive about which companies can offer pensions, they are traditionally offered more easily by government employers or larger companies that have been around for some time.

Employees Have No Access to Fund Management

Once you are contributing to a pension fund, the company manages your money.

When retirement comes around, you will have access to all of it at once. This can be helpful for those who worry about not having enough income throughout old age if drawn out over years or decades.

However, if you need or want to access some of your contributions before retirement (or even during working years), companies that use pensions don’t generally allow their employees this flexibility.

Restricted Withdrawals and Transfers

If you ever plan on starting your own business or feel like switching jobs frequently before retirement, this might not be the best option for you because of the restrictions they place on withdrawals and transfers.

You won’t find any individualized account statements either. You’ll receive a single statement with all of your contributions and earnings, including interest. If you’re the kind of person who appreciates control over his or her own money, you might not like this plan.

What Is a 401(k) Plan?

A 401(k) is a type of retirement savings plan that gives tax advantages to employees when they contribute.

Offering the option for your employer to match, which is essentially free money, makes this an attractive option. 

The way it works is that you’ll automatically save a portion of every paycheck and the employer matches dollar-for-dollar up to a set amount each year. For example, if you put in $100 each month and your employer matches, you’ll have saved $1,200 by the end of the year.

Pros and Cons of a 401(k) Plan

Pros_and_Cons_of_a_401k_Plan

Here are some of the upsides and downsides of a 401(k) plan to guide you in making your decision.

Employees Have Access to Fund Management

Though you don’t have total control over your account, most plans allow you to shift around between different investment types.

Your employer will usually offer a wide variety of funds and investments to choose from so even if they won’t let you withdraw money whenever you want, at least employees can shift some cash around in the event something big happens in the market.

Tax-Deferred Growth

Contributions and earnings from these plans aren’t taxed until withdrawal. This means there’s no need to track how much will get withheld from your monthly paycheck for taxes. You simply set up a direct deposit and let the tax savings roll in.

Visible Account Statements

Depending on how detailed your plan is, you can access detailed information about everything in your account online. You’ll also see all of it on a yearly summary statement that will show your contributions and earnings over the past year.

If you’re used to having this kind of control over your money, it’s hard to give up even with a defined contribution retirement plan, like a 401(k).

The ability to see exactly where your money is going and how it’s performing is empowering. It gives employees total transparency so they know if their employer offering matching funds keeps its promises or if they are putting too much into certain

Employees Must Invest for Long Periods of Time

A great thing about 401(k) plans is that you’re investing for retirement, not paying bills right now.

That means when investment markets fall (which they always do), it’s not such a drastic shift in your overall savings like with a pension plan since these things are meant to last years into the future.

However, that can be a bad thing too. You’ll have to wait a long time before you even get your first taste of tax-deferred growth and by then, inflation could eat up your gains pretty quickly.

No Guaranteed Payout Amounts

Also, because the funds are invested for years into the future, there’s no guarantee how much money you’ll wind up with when you go to start drawing from it.

Your employer might not offer matching contributions forever either which would severely impact your ability to accumulate savings.

That said, if employers are responsible for their matching contributions, there is still some security in knowing that they will continue to match after an economic downturn or recession since they understand that this may erode employee confidence in them as an employer.

Unclear Death Benefits

Some people choose to keep their 401(k) plan even after they retire if they have a spouse who might continue working and therefore be able to defer taxes on any withdrawals made before age 59 1/2. Some people take it out early if they need the cash sooner while others leave it alone until death when beneficiaries can’t withdraw funds at all.

The only way to be sure what happens is if you know how the plan is set up and if your employer tells you, they aren’t legally obligated to tell you until after you retire so it’s largely up to how honest and forthcoming your employer will be with any questions you ask.

Even worse, some plans offer no benefits at all for death beneficiaries which is one of the main reasons why most people choose private pension plans or IRAs instead.

Pension vs 401(k)

The truth is it’s not always easy to say whether a pension or 401(k) will be the better plan for any one person.

Your age, income, job security, spouse’s employment status, and individual financial needs all factor into how you decide which type of plan works best for your overall savings goal. 

That said, just because there are no cut-and-dry answers doesn’t mean you can’t have an informed opinion on the matter.

The main difference between these two plans is that pensions are defined benefit plans which means that you have a guaranteed payout amount that you can expect from them no matter how the stock market performs.

In contrast, 401(k) plans are defined contribution plans which means that your employer takes responsibility for making contributions to your account but there is no guarantee on how much you’ll actually have when you retire.

Pensions require a lot more long-term planning due to their inflexibility and the fact that they offer no liquidity so they aren’t as good for those who may need access to funds before retirement age, especially if they become unemployed or lose their job unexpectedly.

In contrast, 401(k) plans are far more flexible and can be tailored to meet your needs at any point in time. Also, because pension plans do not offer employee contributions, they also lack transparency and tend to be more expensive.

Final Thoughts

Overall, the main thing to keep in mind is that a pension plan and a 401(k) both have their pros and cons.

Some choose one over the other for various reasons but at least you now know some of the finer details about each type of retirement savings account.

You can use this knowledge to help make an informed decision on whether or not this choice will be best for your financial situation. 

Fortunately, most people have more than one option from which to choose from but it’s important to understand key differences so you can make sure you’re making the right decisions throughout your life.

The amount that you contribute to your 401(k) will vary depending on your salary and the level of matching contributions offered by employers. If you aren't sure how much to set aside, it's best to talk to someone who works with the company's HR department so you can figure out how much you can afford to put aside each paycheck.
It depends on your age, income, savings goals, and financial obligations but most experts recommend saving at least 10% of whatever you make every single month. It's also best to start saving as soon as possible so even if you can't contribute enough now, try to make sure that it's something you set aside eventually.
You will not be taxed on any income that was contributed until the funds are withdrawn from the account which means that it's all additional savings for your retirement fund.
The interest rate on a 401(k) account depends largely on where you invest your funds but fortunately, most companies offer more than one choice, and many times, financial advisers will help match you to a plan that will be best for you.
Most employers offer matching contributions but vesting is when you can actually claim those funds. This means that you won't be able to withdraw these funds until you reach a certain amount of time working for the company.

401(k) Plan | A Complete Beginner's Guide

401(k) Meaning

The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.

Traditional 401(k) vs Roth 401(k)

There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.

Contributing to Your 401(k) Retirement Plan

Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.

Pension vs 401(k)

Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.

How Much Should I Contribute to My 401(k)?

Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.

Plan in Advance

Allow us to help you prepare and plan for your retirement ahead. Contact a financial advisor in St Helena, CA or visit our financial advisor page for other details.

401(k) Plan FAQs

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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