If you are thinking of starting your journey with retirement savings, choosing which retirement plan to go for is the first question you will face. There are several retirement saving accounts, among which the most famous are the pension and 401(k) plans. So, let’s understand what these accounts offer and how they work.
What is a Pension Plan?
Used as a retirement-savings plan, a pension is a fund that gives you a guaranteed monthly payment after your retirement. This works as a workplace benefit where some organizations will need their employee to complete a certain number of years in the company to start receiving a pension.
An employee does not have to make any contributions to a pension plan. Instead, an employer makes all the contributions to their employee’s pension plan. As a result, you only have limited supervision over the contributions made and how you will be able to receive your pension. Since you do not have control over how and when you will receive the pension post-retirement, it will depend on your organization. Some may give their employees their pension in a lump sum after retirement, while some prefer making monthly payments. Although monthly pension payments are more common, they might change from company to company. Some pension plans allow spousal benefits, where your spouse continues to receive your pension funds after your death. If you select this option, it would be difficult to change it later, so be careful before choosing it.
What is a 401(k) Plan?
A 401(k) plan is another type of retirement plan where the employee primarily contributes from their salary to save for retirement. Additionally, your employer can choose to match your contributions, meaning they can fill in additional money to your retirement saving account after making the contribution. For example, let’s assume you contribute 6% of your salary into your 401(k) plan, and your employer matches 50% of your contributions. Further, assuming you earn $100,000, that makes your contribution $6,000 and the employer’s contribution $3,000. A 401(k) plan is a great way to save up some funds for your retirement. However, never indulge in money matters without understanding every aspect of it.
Before you go with the 401(k) retirement plan as your retirement saving account, you need to know that there is a yearly contribution limit that is set by the IRS (Internal Revenue System). Since this retirement account has tax advantages, you cannot make random contributions anytime you want. Instead, the IRS sets a certain contribution limit that changes yearly, adjusting to the cost-of-living conditions of the country.
The elective deferral limit for 2023 is $22,500, which was $20,500 in 2022. In addition to the yearly contributions, people above 50 can make catch-up contributions at the end of the calendar year. The catch-up contribution limit for 2023 is $7,500.
Pension vs 401(k): What’s the Difference?
|Pension Plan||401(k) Plan|
|Only employer contributes to the plan||An employee contributes and the employer matches the contribution|
|Employer has the full right to decide how to invest funds in it||The employee gets to decide how to invest funds|
|The employer can choose to terminate the plan, and your accrued benefits are frozen||An employer can terminate the plan, and your benefits will belong to you|
|Income is guaranteed||Income depends on your contributions|
1. Contribution Limit
The employees contribute to their 401(k) plan, while their employer can match this contribution. Note that an employer does not compulsorily have to contribute to your retirement plan.
In contrast, a pension plan is sponsored by your employer, where the benefits are calculated with a formula that considers your salary history and employment length. The employer will continue to contribute to your pension plan if you continue working for them.
2. Fund Investment
A 401(k) plan allows you to choose how to invest your funds and select from the various investment options. However, your employer can choose how the funds are invested with a pension plan.
3. Termination of Plan
Your employer can terminate your 401(k) plan, and if that happens, the benefits of this account belong to you. In addition, the employer will have to distribute the assets, and you can roll over the funds to other IRA plans.
In a pension plan, an employer can also terminate it, but here, your benefits are frozen. It means you can receive all the benefits you have earned to the point of termination, but you cannot get any additional credits.
With a 401(k) plan, your retirement will depend on your and your employer’s contributions and investment performance. While in the pension plan, the guaranteed retirement income is calculated depending on your compensation, years of service, and age.
Pension vs 401(k): Which is Better for You?
The “better” aspect of your retirement account choice depends on your priorities and the situation. A pension would not allow you to choose your investment choice. If this is your main concern, a 401(k) plan is better for you. Moreover, you get more control of your contribution into your retirement account with a 401(k) as long as you stay within the annual contribution limit. While with a pension plan, your employer has complete control over the contribution amount.
Both of these retirement accounts have their own benefits and drawbacks. Hence, which one is better for you really depends on your requirements and situation. However, if you want to gain more control over choosing the funds you want to invest in and the amount you want to contribute, investing in a 401(k) plan is ideal.
Contact us if you need help deciding which retirement account is best for you!
Can a pension plan go bankrupt?
If your employer does not sponsor your pension plan with the Pension Benefit Guaranty Corporation, your pension plan can go belly up. However, since most private plans are insured, the pensioner is protected.
Can I take my pension early?
No, early pension withdrawal is not possible. However, nowadays, several pension operators hold pension advances where you can use collateral for some early pension cash. This offer is attached with high-interest rates and fees. In military pension, this pension advance is illegal.
Can I get early payments from my 401(k)?
You can make early withdrawals in your 401(k) plan, but you will have to pay a 10% fee. However, the IRS has made some exceptions where early withdrawals are not subjected to this additional penalty.
Can I have both a pension and 401(k)?
Yes, you can have both a 401(k) and a pension plan.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments. If you need help and guidance with traditional or alternative investments, call him today (866) 639-0066.