401(k) and conventional pension plans work for the betterment of employees. Both are primarily funded by the employees.
Both these plans offer some great advantages like tax savings, income stream after retirement, and interest compounding on savings.
Let us discuss what are these plans and the key differences between 401(k) and pension plans.
What is a Pension Plan?
A pension plan is an employer-sponsor program for an employee that is used to pay the employee on retirement.
A pension plan is contributed by an employer and employee contributions are optional. The employee receives a pension for the rest of his life after retirement.
Traditional pension plans or defined-benefit plans are costly for employers as they have to contribute all the funds and manage the investment as well.
Therefore, more private companies are shunning traditional pension plans. Defined-benefit or pension plans are still prevalent in the government sector though.
The employer sets a fixed percentage of the salary of the employee as a contribution towards the pension plan. The contribution is then deducted from the gross salary of the employee.
There is no matching contribution from the employer for a conventional pension plan though. However, the reward is life-long for the employee after retirement.
Features of a Pension Plan
The biggest advantage of a traditional pension plan is the guaranteed payout for the employee after retirement. The company must pay the retiree a fixed income for the rest of his life.
If the retired employee passes away, the pension plan would usually pay to the spouse. However, it would be a reduced benefit for the beneficiary.
Like other IRS-qualified plans, a pension plan also offers tax savings to the contributor which is usually an employer in this case.
There is no market risk for the employee in a pension plan as the payment is guaranteed. Even when the employer goes bankrupt, the pension plans are insured by the employer.
Another key feature of defined-benefit plans is their higher contribution limits as compared to defined-contribution plans.
So, employees would benefit and compound more interest on their pension plans if they start early and their employer contributes the maximum amount.
What is a 401(k) Plan?
A 401(k) is a type of pension plan and it is a defined-contribution plan. The contribution is primarily made by the employee and matched by the employer in full or partially.
401(k) plans require a fixed deduction from the employee’s salary. The IRS defines the maximum contribution limit every year for these plans.
An employer can choose to contribute the plan matching the full or partial amount contributed by the employee.
Employees cannot withdraw funds from 401(k) plans before the age of 59 ½. The payout at retirement also depends on the performance of the investment funds.
The investment responsibility of 401(k) rests with the employee. Thus, maximizing the returns on contributions depends on how well the investment vehicle performs in the long run.
Features of a 401(k) Plan
Contributions to 401(k) plans reduce the taxable income for the employees. The employer contribution is also a tax-deductible expense. Thus, both parties enjoy a tax benefit with this type of plan.
Traditional 401(k) plans do not incur taxes at the time of investment. The income is taxed when the employee withdraws these funds.
Another key feature of these plans is the choice of an investment portfolio. The employees can choose to invest, not to invest, and the investment options themselves.
The employer matching contribution is a key differentiation from pension plans as well. In most cases, the employer would make a 100% matching contribution that grows the retirement savings exceptionally quicker.
These plans are widely used by the private sector. So, when an employee changes the job, the 401(k) contributed plans can be shifted to the new employer called the “rollover” of the retirement contribution.
Differences Between 401(k) and Pension Plans
So, let us now summarize some key differences between these two plans for an employee and the employer perspective.
Guaranteed Income
A pension plan is a better option if you are looking for guaranteed income. Pension plan saving funds are also insured by employers. So, there is no risk of losing money for an employee.
Contrarily, the income provided by a 401(k) is less secured as the investment returns may reduce the capital amount. That is the reason most employees do not invest their contributions or invest in conservative funds.
Who Contributes?
Both are primarily employer-sponsored contribution plans. A pension plan is fully funded by the employee.
Whereas, a 401(k) is usually funded by an employee and matched by the employer.
Required Tenure
You have to wait until retirement for a pension plan. Although the pension plan rollover is possible it is more difficult.
The tenure restrictions are flexible with 401(k) plans and you can switch a job at any time with the easy rollover of the funds.
Control Over Investment
A pension plan is controlled and managed by the employer. It means the responsibility of the investment performance also rests with the employer.
On the other hand, a 401(k) plan gives full control and flexibility of investment choice to the employee. However, it also means the responsibility of the investment vehicle performance rests with the employee.
Who Holds the Funds?
Pension plans are held by the employer as long as the employee is in service and beyond. The employee would receive a fixed income (as decided in the contract) for the rest of their life after retirement.
401(k) plans are held in segregated contribution accounts. The employee can take the contributed plan savings to the next employer when needed.
Tax Savings
Both these types of pension plans come with tax savings.
A pension contribution is tax-deductible for the employer and the employee receives a tax-free income after retirement.
The deduction for the contributions for both these plans is tax-deductible expenses for the employees.
The employer contribution for the 401(k) plan is also tax saving for the employer.
Early Withdrawal Option
There are no early withdrawal options for both of these plans.
If you withdraw money from a 401(k) plan before the age of 59 ½, you’ll receive a 10% penalty from the IRS. The same holds for early withdrawals from a conventional pension plan as well.
Can you 401(k) and a Pension Plan at the Same Time?
Yes, an employee can have a pension plan and a 401(k) plan as well. However, both plans cannot be started at the same time.
Since pension plans are common in the government sector nowadays, employees may want to save more for retirement.
Therefore, if you have a pension plan, you can start contributing towards a 401(k) or an IRA.
However, when you start an IRA or even a traditional 401(k), it is unlikely that your employer will match the contributions as the pension would be already in place.
Inflation and other costs might prompt you to open another retirement contribution plan. You may consult your employer to get an idea of how much you’d receive at retirement.
Nonetheless, it is a good idea to save more for your retirement if you can afford to contribute more right now.
What If you Don’t Have Any 401(k) and Pension Plan?
In some cases, employees may not have access to a pension plan or even a 401(k)-contribution plan. This happens mostly for contract employees, self-employed persons, freelancers, and contractors.
If your employer does not offer any of these plans, you can get your own.
An individual retirement account or IRA is an optional retirement contribution plan that anyone can start at any time.
Employees having a pension or 401(k) plan can also open an IRA for increased savings. However, the IRS sets lower contribution limits for IRA plans than others.
If you want further flexibility in using the funds at any time, you can open a Roth IRA. This plan allows you to access your retirement savings at any time without a penalty.
The drawbacks of IRAs are the minimum contributions and not matching contributions from the employer.
Final Thoughts on 401(k) Vs Pension Plans
Pension plans were more common in previous decades when private and government sectors offered these plans.
Due to higher costs, pension plans are no longer popular in the private sector.
Depending on the features, both plans still offer great benefits to the beneficiaries. If you have a choice, you can use both these plans to maximize your retirement benefits.
It is unlikely that your private employer would offer a pension plan. Therefore, you can work to maximize the contribution toward the 401(k) and optionally build an IRA as well.
In short, if you are looking for certainty and guaranteed income, choose a conventional pension plan.
If you want more control over your retirement fund investments, choose the 401(k) plan.
