Last Updated: February 13, 2024
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:
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.
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.
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.
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 quality IRA 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.
|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.
|NOTE: Retirement is the ideal time for travel. Check out the top-rated travel insurance for seniors before leaving home.
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.]
|NOTE: Investment advice for retirement plans and accounts has been automated with the introduction of Robo-Advisors. If you’re planning to invest, you may consider seeking the help of the best Robo-Advisor.
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.
A typical pension ranges from $9,000 for private pensions to $22,000 for state or local pensions and $30,000 for federal pensions. The average monthly Social Security benefit for retired employees is around $1,400 per month (less than $17,000 a year).
The main difference between these two is that employers offer 401(k) accounts, while IRAs (serving as personal pension plans) are funded and managed by individuals.
The average return on a 401(k) is 8 to 10% on invested funds. But depending on the market, this return can fall to a 5% return.
In the debate, pension vs 401k, pensions are still considered to be superior to 401(k)s because of the guaranteed lifetime payments. Pensions, however, are not as available as 401(k)s. But even with a 401(k) plan, you can accumulate substantial savings and enjoy a comfortable retirement.