By Paul S. McNulty, CFP®
With many kinds of retirement plans, it can be hard to tell the differences between them at first glance. Two of the biggest types of retirement plans offered by employers are the 401(k) plan and the pension plan. An employer typically provides one or the other, but not both. While it’s unlikely that you’ll have a choice between the two, you’ll probably come across one of these plans throughout your career, so it’s essential to understand the differences between the two.
What Is A 401(k)?
A 401(k) is a common retirement plan offered by employers. In a 401(k) you elect to contribute part of your salary into a retirement account. You can choose from a range of investments such as index funds, mutual funds, and target-date funds. You also have the ability to change your investments, however, they are limited to the investments your employer offers. You can contribute up to $19,500 (as of 2021) each year, and if you are 50 years of age or older, an additional $6,500 catch-up contribution. (1) Your employer may also choose to match your contributions up to a certain amount.
There are two types of 401(k) plans: a traditional 401(k) and a Roth 401(k). In a traditional 401(k), your contribution is taken from your salary pre-tax. Your traditional 401(k) grows tax-deferred, and you only pay taxes when you withdraw from the account in retirement. Because these contributions are tax-deferred, contributing to a traditional 401(k) means you lower your taxable income at the time you contribute.
A Roth 401(k) is funded with money after you’ve already paid taxes on it. The money in your Roth 401(k) grows tax-free in your account, and since you’ve already paid taxes on your contributions, when you withdraw funds, you withdraw them tax-free. Thus, the key difference between the two boils down to when you pay taxes. If your employer offers both, you have to decide whether it makes sense for you to pay taxes now or when you retire. 401(k) plans are also generally subject to required minimum distributions, meaning you will need to begin withdrawing from your plan when you reach age 70½. (2)
What Is A Pension Plan?
A pension plan is an employer-sponsored plan that guarantees an amount of income in retirement. The amount you receive in retirement is determined by a few factors, such as your length of employment, your salary, your age at retirement, and any other specifications set by the employer.
Your employer is responsible for contributing to the plan and all the investment risk is on them as well. However, you may need to work several years at the organization before you are eligible for a pension plan. Additionally, with a pension plan you have no control over how it is invested; although, this means that you do not have to worry about asset allocation as you get closer to retirement. Depending on the plan, you may be allowed to contribute part of your salary as well. But typically pension plans mean that you do not need to use your salary to fund your retirement. You are also guaranteed regular payments for the rest of your life, though the plan might offer you the choice of a lump-sum payment.
Which Plan Is Better: 401(k) Or Pension Plan?
Both plans have their advantages and disadvantages. Pension plans have been around longer, however, 401(k) plans are much more common today. In fact, as of March 2018, 60% of employees had access to a defined contribution plan such as a 401(k), while only 26% had access to a pension plan. (3) If you have a 401(k), it is up to you to save for your retirement. You have more control, but more responsibility as well. With a pension plan, your employer is responsible for funding the plan. If you like knowing you will have a guaranteed income in retirement and prefer not having to contribute any of your own money, a pension plan will be more attractive to you. If you’d rather have more control over how much you put toward retirement, a 401(k) may be better suited for you.
401(k) Vs. Pension Plan: Key Differences
A 401(k) plan is considered a defined-contribution plan, and a pension is a defined-benefit plan. In sum, these two plans differ in the following ways:
- A 401(k) does not have payout guarantees, whereas pension plans do guarantee a set amount of money for the rest of your life.
- 401(k)s are funded by the employee (though some employers will offer a match for a portion of your 401(k) contribution).
- Pension plans are completely funded by your employer.
- With a 401(k) you have control over contributions, while with a pension plan you do not.
Setting Yourself Up For Success
Planning for retirement can feel daunting. You don’t have to figure it out all by yourself. Choosing the right partner as you plan for the future can help you set yourself up for success in retirement. And finding a financial advisor that understands your unique situation and goals doesn’t have to be difficult. At Boston Metro Advisor, our mission is to simplify navigating the complexities of retirement. We understand that retirement plans are not one size fits all. That’s why we work with you to develop a plan tailored to your needs. Contact us for a complimentary consultation by calling (781) 995-0253 or email me directly at [email protected] today!
Paul McNulty is the founder of Boston Metro Advisor with over 20 years of experience helping people navigate the ups and downs of the economy toward the financial future they envision. His education consists of a Bachelor of Science in business administration from the University of Rhode Island and the CERTIFIED FINANCIAL PLANNER™ (CFP®) professional designation.
Paul’s experience and education have made him a multi-faceted professional capable of assisting people with virtually all their financial needs. His services include every facet of retirement planning, from 401(k) rollover services and income planning to wealth management and estate planning. Paul has been active in his community over the years as a youth sports coach. When he’s not spending time with his wife, Cindy, and their two children, who are both recent college graduates, Paul enjoys reading, playing golf, and fishing. Learn more about Paul by connecting with him on LinkedIn.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.