Both types of plans can help finance your retirement, but pensions and 401k plans have several important variations. Pension vs. 401k; let’s look at the difference.
1 What Are the Main Types of Retirement Plans?
Retirement income is generally made up of three types of savings and plans.
- Workplace pension
- Social Security
- Personal retirement savings
The employer makes all contributions to a workplace pension plan, and the benefit is characterized by the plan’s rules
Social Security is a benefit that offers limited additional income for qualified retirees. An individual must pay into the Social Security program throughout their working years to be eligible for benefits.
A 401k is a type of personal retirement savings account where you put aside a certain amount each month from your salary. The employee chooses and manages the investments, for example, stocks, bonds, and mutual funds.
2 What is a 401k Plan?
A 401k plan is named after a section of the U.S. Internal Revenue Code and is also known as a defined-contribution plan.
Defined contribution entails the savings paid into the plan by the participant and the gains on the money invested (which have tax-advantages).
There are two fundamental types of 401ks: traditional and Roth.
- In a traditional 401k, when employees make contributions, they reduce their income taxes for the year, and investment growth occurs tax-free. However, tax is paid on withdrawal.
- A Roth is the opposite where employees make contributions after they have paid income tax, but when they make withdrawals, they are tax-free.
Usually, a 401k plan will include a menu of investment choices across several asset classes that individuals can choose from. These can be collective investment trusts, stocks, bonds, mutual funds, exchange-traded funds (ETFs), or other kinds of institutional investment offerings.
Participants who chose not to manage their accounts can opt for a managed account if they feel uneasy making their own choices. Managed accounts typically offer an all-in-one investment option.
3 Who Pays Into a 401k Plan?
401ks are company-sponsored retirement accounts that employees can add to via automatic payroll withholding.
Employers may also make matching contributions, partially or for the same amount.
You earn £100,000
Your contributions to the 401k are 6%, which is $6,000 per year.
Your employer offers a 50% matching contribution, which is an additional $3,000 added to your plan each year.
4 Why Might a 401k Plan Be a Bad Idea?
There is no cap on the growth of an individual 401k account; however, the main disadvantage of a 401k plan is that there is no floor, and as such, there is higher return risk. 401ks can lose value if the underlying portfolio performs poorly.
5 What is a Pension Plan?
A pension plan is also known as a defined benefit retirement plan. It is called such because the benefits are characterized by a set of rules or factors, like salary history or length of employment.
Pensions deliver a continuing, steady income for life for retirees.
Private-sector pensions will usually not provide any inflation or cost-of-living increases, whereas non-profit or public sector pension plans will.
The employer should put away enough funds to cover the cost of benefits to all employees in the plan, as well as their beneficiaries upon their death, for example, a spouse.
The calculation of the obligation for future benefits can be complex and is based upon a set of statistical rules formed by the Employee Retirement Income Security Act (ERISA) rules.
6 Why Might a Pension Plan Be a Bad Idea?
If the company’s portfolio performs poorly, benefits will likely be reduced.
7 Pension vs. 401k: What Are the Key Differences
- The main difference between a 401k plan and a traditional pension plan is the difference between a defined-contribution plan and a defined-benefit plan.
- Your employer is much more likely to offer a 401k plan than a pension plan in its benefits package.
- Private pensions are protected and are insured by the Pension Benefit Guaranty Corporation (PBGC). Employers pay regular premiums for this insurance; therefore, there is less risk than with 401k plans.
- 401k plans are designed to be a supplement to pension plans, but pension plans have become rarer because they are more expensive and more complex to manage.
- Pensions provide a guaranteed income during retirement for life, but If you were to outlive your 401k savings, there would be no more money to draw from because there is no longevity protection with a 401k.
- 401k plans put all the risk in the hands of individual employees.
- Pension plan benefits are usually subject to federal taxes, but some state and municipal pension payments may not be subject to state income taxes.
8 How Can I Ensure a Financially Secure Retirement?
To ensure a financially secure retirement, don’t rely on Social Security, which is likely not to be enough to live on, start planning as early as possible, and explore your work-based plan options.
Check out any online pension vs. 401k calculators to assess your needs.
While retirement planning is exceedingly essential, it can also be overwhelming and confusing. If you’d rather not go it alone, consult with a knowledgeable professional for further advice on this topic.
What plans do you have in place for your retirement? Did your retirement plans turn out as they should? Please comment below.