Pension vs 401k – the differences between these two retirement plans can be confusing. In this article, we look at the differences and consider which might be the better option for you. We define both plans and explain many of the confusing concepts.
What Is a Pension?
A pension is a retirement plan that provides employees with a monthly income upon retirement. It’s funded by an employer (or the government), who has made contributions to a pool of funds out of pre-tax paycheck deductions, which the employee will receive as a regular monthly payment upon retiring.
The full responsibility of funding the plan and managing the pensions and investments falls upon the employer, which is one reason why many private-sector companies have ceased to offer pensions, while government organizations still do.
There are two main types of pension plans:
Defined Benefit
This type of plan determines the retirement benefits based on earnings and length of employment. The amount of the benefit the employee receives is predetermined, regardless of the success of the employer’s investments. An employee, however, cannot withdraw these funds before retirement but must wait to receive them as a lifetime annuity or a lump sum at certain retirement age.
Defined Contribution
With this tax-deferred plan, employees contribute a certain amount of money or a percentage of their paycheck to their pension plans. The employer can match the employee’s annual contributions, either by covering a certain portion of the added funds or by adding a predetermined amount of money.
When considering the pension vs 401k debate, remember that with a pension an employee can receive a monthly pension payment ranging from 50% to 85%, depending on retirement age and income. Unfortunately, some employers may choose to freeze payments to the benefits package of a plan, so your pension does not accrue additional funds, regardless of the number of years you had worked or any pay raises you had received.
NOTE: The pay-as-you-go pension plan is funded entirely by employee contributions, with no matching contribution by the employer.
What Is a 401(k)?
Is a 401(k) a pension? No. A 401(k) is a retirement account set up by an employer. The employee contributes a certain percentage of their salary and puts it into long-term investments. The funds deposited into this account are then invested in stocks, bonds, mutual funds, or cash. The money invested in these funds is usually tax-free, and the employer can make matching contributions to the account—either a dollar-for-dollar contribution or 50% of an annual contribution.
The 401(k) is a defined contribution plan, with two versions (below), which are quite similar but taxed in different ways. An employee can have either one or both.
Traditional 401(k)
Both employee and employer can contribute money up to a certain limit set up by the IRS, which is $19,500 per year for employees under 50 years old and $26,000 for those 50 and older. The contributed money in this account comes from tax-free dollars, although the distributions received as payment are taxable.
Roth 401(k)
Money deposited in a Roth 401(k) comes from money that has already been taxed. Distributions, then, later received from this account, are not taxable, as long as the recipient is qualified. Additionally, funds can be withdrawn from this account without penalties if the account has been held for at least five years.
What happens to your 401(k) account if you change employers? Since this is classified as personal pension planning, it’s up to you to decide what will happen to your account. There are several options, but the most popular ones are to either transfer your funds to a 401(k) plan with your new employer or have your funds rolled over to an IRA (Individual Retirement Account). To find out more about qualityIRA accounts, check out our article here.
NOTE: A Roth IRA can serve as a tax-free savings account, which you can either use in retirement or leave as an inheritance.
What Is the Difference Between a Pension and a 401(K)?
What are a pension plan and a 401(k)? We consider six of the most pressing questions to fully grasp the differences between these two:
Is Your Income Stable and Fixed With These Plans?
Upon retirement with pensions, you receive a fixed monthly payment for the remainder of your life, i.e., a stable income for as long as you live. The 401(k) plans do not offer this security, since you can receive payments as long as there is still money in the account. If the funds run out, you’ll be left with no income. It’s a good idea, then, to have some additional savings.
Who Contributes to a Pension and a 401(K) Plan?
Traditionally, employers contribute to a company pension plan, with the possibility of employees adding their own contribution to the fund, while 401(k)s are funded by the employees themselves, with a possible matching investment from their employer.
Are These Plans Susceptible to Changes?
Both of these funds are dependent upon investment growth and, therefore, susceptible to changes. Pensions are more secure since the investments deposited in pension funds are decided upon by investment experts hired by the company that is paying for the pensions.
The 401(k) investments are chosen by employees who are usually not investment experts and can make questionable decisions when it comes to handling their finances.
What’s the Expected Rate of Both Plans?
The rate of return cannot be determined with certainty in 401(k) vs pension payouts, since it largely depends on market performance—although an expected return rate on retirement investments is typically 8 or 9%.
How Do These Plans Work With Taxes?
Most of the funds deposited in retirement plans come from pre-tax dollars. The beneficiary of the retirement plan, then—whether it be a pension or a traditional 401(k)—has to pay taxes upon receipt of these funds. Roth 401(k) accounts are an exception because the money deposited in these accounts is already taxed, i.e., tax-free.
When and How Can the Money Be Withdrawn From These Accounts?
How does a pension work? Pensions usually give their users access to their funds at full retirement age, which is currently 66 (depending upon your birth date), offering them as monthly payments or an annuity. Although users can begin using their benefits sooner than the retirement age, this is not recommended because future payments will not be as much as they would be after retirement. With 401(k)s, you’re entitled to a withdrawal of your funds as early as five years from the establishment of your account.
NOTE: 401(k) plans first became available in 1978. Previously, the retirement system had relied solely on pensions.
Key Takeaways
| Pensions provide payment stability for your retirement years. |
| A 401(k) allows you to control your finances and expand your investment portfolio. |
| Pensions are still considered a more attractive option. |
| The ideal situation is to have both a pension and a 401(k), or equivalent. |
Pension vs 401k: Which Is Better?
A pension plan vs 401(k) mindset most always poses a dilemma with employees. Both pensions and 401(k)s bring to the table their own benefits—although there are some downsides to both of these options. Pensions, however, are still considered to be the better option by both experts and laymen.
The main arguments for pensions are that the employee is not required to add any money to the pension fund and their regular monthly payment is guaranteed. The downside of a pension is that individuals have no access or control over their funds and are not entitled to withdraw the money at any point in their career.
The 401(k) option leaves all decisions regarding deposits and investments entirely to the employee. This account has certain benefits that are deficient in pensions, such as the possibility to choose your own investments, which may provide a significantly larger return and secure more money for your retirement. Additionally, you can withdraw money from your 401(k) account and invest it somewhere else.
Can You Have Both a Pension and a 401(K) Plan?
It is possible (even advisable) to have both a pension plan and a 401(k). Since you’re not fully in control of your pensions and investments, you can never be 100% certain of the benefits you’ll receive upon retirement—so a backup plan is a sound choice.
If you want to ensure a comfortable retirement, you should invest in a defined contribution plan, such as a 401(k) or 403(b), depending on what your employer offers. Another option for a retirement investment is an IRA (traditional or Roth IRA). You can invest in both a 401(k) and an IRA, as long as your contributions don’t exceed the determined maximum amount.
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Pension-Related Terms
403(b) vs 401(k)
A 403(b) is a retirement plan offered to nonprofit organizations and government employees. The main difference between 401(k) and 403(b) is that a 401(k) is traditionally offered to employees of for-profit companies, while a 403(b) is offered to nonprofits. When thinking 401(a) vs 403(b), the better choice would be the latter, since it imposes no obligations.
401(a) vs 401(k)
All 401(a) plans are offered by government organizations and nonprofits. The 401(k) is more popular in the private sector. The main difference between these plans is that a 401(a) often requires mandatory payments, while a 401(k) doesn’t impose such requirements.
Pension vs Social Security
While pensions are funded by an employer, Social Security is a federal insurance scheme to provide a basic income for elderly Americans. Even though everyone is entitled to Social Security benefits, the funds provided through this program do not cover all living costs. The retiree, then, should have another source of retirement funds—either a pension or a 401(k).
A benefits package of a pension equals the number of funds that are set aside to serve as a source of income during your retirement years. But even though you retire, it doesn’t mean that you are automatically entitled to a pension.
Union Pension vs 401k
In the case of losing your pension because your employer can no longer afford to pay into it or has declared bankruptcy, you’re protected by The Employee Retirement Income Security Act (ERISA). [Note the aspects of a 401(k) above.]
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Conclusion
Pensions and 401(k)s as a form of personal pension planning are the main sources of retirement income in the US. Despite their differences, both do provide a sense of security, albeit on different levels. A 401(k) is more suitable for those comfortable with investments and not afraid of financial risks. A pension is a better choice for those that don’t want to concern themselves with complex financial instruments.
FAQs
What are the key differences between a pension and a 401 K account? ›
A pension plan is funded and controlled by the employer, while a 401(k) is primarily funded by the employee, who may choose how the money is invested. Some employers will match a portion of your 401(k) contributions. A 401(k) allows you control over your fund contributions, while a pension plan does not.
Is it better to have a pension or 401k? ›Pensions offer greater stability than 401(k) plans. With your pension, you are guaranteed a fixed monthly payment every month when you retire. Because it's a fixed amount, you'll be able to budget based on steady payments from your pension and Social Security benefits. A 401(k) is less stable.
Why were pensions replaced with 401ks? ›401(k) plans have largely replaced pensions in today's workplace. With a 401(k), the employee assumes all the risk associated with their investments. With a pension, the investment risk is borne by their employer. 401(k) investments can grow more quickly than traditional, conservative pension plans.
What are the changes to retirement accounts in 2023? ›In 2023, you can contribute an additional $7,500 per year if you are age 50 or older. Under new rules, if you're ages 60, 61, 62 or 63, you can make an additional catch-up contribution of $10,000 or 50% more than your regular catch-up contribution (whichever is greater).
Can you have both a pension and a 401k? ›Fewer companies today offer traditional pensions; however, you can have a pension and still contribute to a 401(k) and an IRA. Contributing to a variety of retirement vehicles can be a smart retirement strategy.
Why did pensions go away? ›In reality, large corporations were lobbying Congress to shut down their pension plans because they were too expensive to administer, and the employer held all of the investment risk. Corporate America needed a way to reduce costs and transfer the risk from the company onto the employee.
What are the cons of a pension? ›One downside of pension plans is that they typically have strict withdrawal and transfer rules. For example, in most cases, employees cannot access their pension benefits until they reach retirement age. Also, if they leave their job before retirement, they may be unable to take their pension with them.
What is one advantage of a 401 K over a traditional pension? ›A pension is a retirement-savings plan, typically employer-funded, that gives you regular payments in retirement. A 401(k) is a workplace retirement plan that gives employees a tax break when they contribute.
What is the best benefit of a pension? ›While those advantages are important, defined-benefit plans offer some pros, too: Income that shouldn't run out: One of the biggest benefits of a pension plan is that it typically pays until your death, meaning you will not outlive your income, a real risk with 401(k), 403(b) and other such plans.
Are companies getting rid of pensions? ›If you're in the United States, the answer is likely very few. Across the private sector, defined benefit plans, including pensions, are on the decline. While in the 1980s about 60% of Americans had access to pension plans, that number has dropped to 14% today.
When did the US get rid of pensions? ›
Since the 1980s, 401(k) accounts have effectively replaced pensions to become one of the most popular retirement plans for American workers.
When did companies get rid of pensions? ›By the turn of the 20th century, many corporations began to grow and offer pensions. By 1960, nearly half of the private sector workforce had a pension. However, private sector pensions began to decline in the 1980s following a series of laws passed by the Reagan Administration.
What is the new 401k rule for 2023? ›The IRS's 401(k) contribution increase in 2023 is a big deal. The agency recently announced an increase in the pre-tax 401(k) limit—employees can now contribute up to $22,500 of their salary towards retirement accounts each year. This is a nearly 10% increase from the previous year's limit of $20,500.
What are the 3 biggest Social Security changes in 2023? ›- Beneficiaries Got an 8.7% COLA Increase.
- Increased Maximum Monthly Payout at Full Retirement Age.
- Early Claimants' Earnings Limits Increased.
- Maximum Taxable Earnings Rose to $160,200.
- Social Security Disability Benefits and Income Thresholds Increased.
Maximum 401(k) Contribution Limits for 2023
Total 401(k) plan contributions by an employee and an employer cannot exceed $66,000 in 2023. Catch-up contributions bump the 2023 maximum to $73,500 for employees who are 50 or older. Total contributions cannot exceed 100% of an employee's annual compensation.
Social Security does not count pension payments, annuities, or the interest or dividends from your savings and investments as earnings. They do not lower your Social Security retirement benefits.
How long does a pension last for? ›Pension payments are made for the rest of your life, no matter how long you live, and can possibly continue after death with your spouse. Lump-sum payments give you more control over your money, allowing you the flexibility of spending it or investing it when and how you see fit.
Is a pension for life? ›Because pension plans are intended to provide periodic payments for life, certain forms of payment are required by law. For single employees, the required form of payment is a straight-life annuity, which typically provides a monthly payment based on the plan formula.
Are pensions declining? ›Due to unprecedented market volatility, the aggregated funded ratio for state and local pension plans is 77.9% as of July 2022, down from 84.8% in 2021, representing the largest decline in funded ratio since the Great Recession.
What percentage of American workers have a pension? ›As of March 2022, 69 percent of private industry workers had access to retirement benefits (either defined benefit or defined contribution plans), while 92 percent of state and local government workers had access.
Does anyone offer pensions anymore? ›
While not all employers offer pensions, many in the workforce still do. Oftentimes, the type of job dictates whether or not it comes with a pension. If you're interested in this type of retirement income, it's important to know the types of careers that offer it to help you narrow down your job search.
How much is the average pension per month? ›Average Monthly Retirement Income
According to data from the BLS, average incomes in 2021 after taxes were as follows for older households: 65-74 years: $59,872 per year or $4,989 per month. 75 and older: $43,217 per year or $3,601 per month.
Only defined-benefit pension plans can be at risk of underfunding because an employee, not the employer, bears the investment risk in defined-contribution plans.
Is it better to take a lump sum or monthly pension? ›Invest how you want: If you want to continue growing the value of your pension, taking a lump sum gives you more freedom to invest in a way that suits you. This approach could yield higher returns, but, of course, there's always the chance that your pension will decrease in value at points too.
What is a typical pension payout? ›In most states, a final average salary — also called final average compensation — is the average of the last five years of work, or the last three years. Other states use the three or five highest years of salary, rather than the years at the end of your career.
Is a pension worth staying at a job? ›When is a Pension Worth a Thought? If you love the work, and your employer values you, then it makes sense to consider your pension. Staying at a job for the benefits should be a consideration if you genuinely have no other options in life.
Do I need to save for retirement if I have a pension? ›Key Takeaways
A good retirement strategy is to contribute to a variety of retirement investments, including 401(k)s and IRAs—even if you already have a pension.
Pension vs Savings
The main benefits of paying into a pension relate to the advantages of tax relief. Therefore, the best savings option to compare a pension to would be an ISA, an account that also comes with tax-related benefits.
The 50 – 70 rule is a quick estimate of how much you could spend during your retirement. It suggests that you should aim for an annual income that is between 50% and 70% of your working income.
Which state has the best pension benefits? ›According to Bankrate's study, Florida is the best state for retirement in 2022, followed by Georgia, Michigan, Ohio and Missouri. Alaska, on the other hand, held last place in our ranking.
What percentage of people have a pension? ›
Pensions. According to the Pension Rights Center, only about one-third of American retirees receive income from defined benefit retirement plans, which reflects the steady decline in pension plans. According to the United States Department of Labor, there were 113,062 pension plans in 1990, but only 46,869 in 2018.
How do I convert my pension to a 401k? ›The ideal way to rollover a pension plan into a 401(k) is through a direct transfer. By doing this, to avoid paying the withdrawal tax on your pension and can defer your taxable income. You can also take the pension as a payout, but it will be taxed.
Are pensions in trouble? ›Across the United States, state and local government-sponsored pension plans are in trouble. They are dangerously underfunded to the extent that their assets are unable to meet future liabilities without either outsize investment returns or huge cash infusions.
Why saving 10% won't get you through retirement? ›Mathematically, 10% Just Isn't Enough
By saving 10%, your money would need to grow at a rate of 6.7% a year for you to retire 40 years from when you start. In order to retire early, after 30 years of contributing, you would need an unrealistically high rate of return of 10.3%.
Understanding an Underfunded Pension Plan
Pensions can be underfunded for a number of reasons. Interest rate changes and stock market losses can greatly reduce the fund's assets. During an economic slowdown, pension plans are susceptible to becoming underfunded.
Once a pension has vested, you should be entitled to keep those funds, even if you're fired. However, you aren't always entitled to all the money in your pension fund. In some cases, you might lose some, or even all, of your pension.
Why are companies freezing their pensions? ›Why Would a Company Freeze Pensions? A company will often choose to freeze a pension plan to cut expenses and reduce its liabilities under the plan. In addition to the direct costs of managing and operating a pension plan, a company is responsible for paying any benefits that accrue.
How do I get the $16728 Social Security bonus? ›To acquire the full amount, you need to maximize your working life and begin collecting your check until age 70. Another way to maximize your check is by asking for a raise every two or three years. Moving companies throughout your career is another way to prove your worth, and generate more money.
Is Social Security going to be taxed in 2023? ›Yes. The rules of the Internal Revenue Service dictate that many who receive Social Security benefits will have to pay an income tax on that money.
How much can a retired person earn without paying taxes in 2023? ›In 2023, this limit on your earnings is $56,520.
If you receive survivors benefits, we use your full retirement age, for retirement benefits when applying the annual earnings test (AET) for retirement or survivors benefits.
Should I be aggressive with my 401k in 2023? ›
It's time to boost 401(k) contributions for 2023: 'You're smart to jump on this,' says advisor. You can defer $22,500 into your 401(k) for 2023, up from the $20,500 limit in 2022. It may be easier to achieve your 2023 retirement savings goals by boosting contributions now, experts say.
Should I stop contributing to my 401k 2023? ›Pros of maxing out your 401(k) in 2023
Maxing out your 401(k) increases your retirement readiness considerably. A $22,500 contribution in 2023 would be worth nearly $340,000 in 2033, assuming an 8% average annual rate of return. That's enough to cover several years of retirement expenses for most people.
Your 401(k) is invested in stocks, meaning your account's value can go up or down depending on the market. If the market drops, you could lose money in your 401(k). This is why it's essential to diversify your investments and not put all your eggs in one basket.
What is the difference between a retirement account and a pension plan? ›The main difference lies in the nature of each product: a pension plan is a saving and investment product, and a retirement annuity is an insurance contract.
What are the benefits of having a pension? ›Your pension helps you to maintain your standard of living in retirement, and savings provides important supplemental income for unforeseen expenses. Group pension plans provide guaranteed, monthly income for life, which makes financial security in retirement much more achievable for those who have them.
What is a pension and how does it work? ›A pension is a type of retirement plan that provides monthly income after you retire from your position. The employer is required to contribute to a pool of funds invested on the employee's benefit. As an employee, you may contribute part of your wages to the plan, too. Not all businesses offer these plans.
What are disadvantages of pension? ›One downside of pension plans is that they typically have strict withdrawal and transfer rules. For example, in most cases, employees cannot access their pension benefits until they reach retirement age. Also, if they leave their job before retirement, they may be unable to take their pension with them.
What are the pros and cons of a pension? ›- 1) Tax benefits. ...
- 2) Anyone can contribute. ...
- 3) Flexibility. ...
- 4) Guaranteed retirement income. ...
- 5) Earn compound interest. ...
- 1) Lack of access. ...
- 2) Investment risks. ...
- 3) It's complicated.
- Most plans have limited flexibility as it relates to quality and quantity of investment options.
- Fees can be high especially in smaller company plans.
- There can be early withdrawal penalties equal to 10% of the amount withdrawn before age 59 1/2.
Your pension should be just one tool in your retirement shed. Chances are, most pensions will not produce enough income to fully cover all your retirement needs, so you should be saving in other accounts as well.
What is a good pension amount? ›
For a quick estimate, try the '50-70' rule. This suggests that you should aim for an annual income that is between 50 and 70 per cent of your working income.
How long does a pension last? ›Pension payments are made for the rest of your life, no matter how long you live, and can possibly continue after death with your spouse. Lump-sum payments give you more control over your money, allowing you the flexibility of spending it or investing it when and how you see fit.
Can you collect a pension and Social Security at the same time? ›Yes. There is nothing that precludes you from getting both a pension and Social Security benefits. But there are some types of pensions that can reduce Social Security payments. Join our fight to protect Social Security.
Do you get Social Security if you have a pension? ›How much will my Social Security benefits be reduced? We'll reduce your Social Security benefits by two-thirds of your government pension. In other words, if you get a monthly civil service pension of $600, two-thirds of that, or $400, must be deducted from your Social Security benefits.
What is the average pension payout per month? ›Average Monthly Retirement Income
According to data from the BLS, average incomes in 2021 after taxes were as follows for older households: 65-74 years: $59,872 per year or $4,989 per month.
Because pension plans are intended to provide periodic payments for life, certain forms of payment are required by law. For single employees, the required form of payment is a straight-life annuity, which typically provides a monthly payment based on the plan formula.
How many years do you have to work to get pension in USA? ›Learn more about credits at www.ssa.gov/planners/credits.html. Although you need at least 10 years of work (40 credits) to qualify for Social Security retirement benefits, we base the amount of your benefit on your highest 35 years of earnings.
What are the two main types of pensions? ›The Employee Retirement Income Security Act (ERISA) covers two types of retirement plans: defined benefit plans and defined contribution plans.