Pensions vs. 401ks
Most people wait until they are eligible to receive social security benefits before retiring. However, because the money provided through social security income typically provides less than half of a retiree’s average earnings in employment, relying on social security income to carry you through retirement is unwise unless you plan to make drastic changes to your standard of living. Employer-sponsored retirement plans are an important benefit that employees should take advantage of to supplement their retirement funds. However, not all retirement accounts are created equal. Maximizing your contribution to an employer-sponsored retirement plan is the best way to ensure you have enough money to carry you through retirement.
Here, we discuss pension plans and 401ks. While both options provide retirees with financial support throughout their retirement, the way these accounts are funded, managed, and distributed are significantly different.
What is a pension?
A pension is a retirement plan in which employees have little involvement or control. While employees may contribute to the account, pensions are typically funded by the employer. There is typically no employee contribution obligation for an employer to fund the account. However, this also means the employer is running the employee’s retirement ship – the employer makes the investment decisions and bears the risk associated with those decisions without the employee’s say, opinion, or involvement.
The money saved in a pension is paid out over retirement to qualifying retirees, providing a set monthly income for the duration of the retiree’s life. To qualify for a pension, generally, employees must work a minimum number of years for the company and reach a certain age. The monthly payment amount is determined by factors such as how much money was contributed to the account and how many years the employee worked for the company paying the pension.
Pensions are not without risk to the employee. Though pensions are generally insured, the benefit pensions provide retirees can be reduced by the company if there are poor investment decisions, if the company declares bankruptcy, or if there are other hardships. Pensions place an enormous burden on the employer, which is why many employers no longer offer this option to employees. Not as popular as they once were, pensions remain a common retirement tool for those employed in the public sector in government jobs.
What is a 401k?
The 401k was designed to supplement pensions, though in recent times it has become the predominant option for retirement savings as pensions have all but disappeared in most private-sector careers. A defined-contribution plan, the 401k shifts the burden of saving for retirement to the employee. While many employers provide a matching contribution to help employees build their retirement account, it is ultimately up to the employee to take advantage of this program, determining how much to contribute toward this savings account, how the funds should be invested, and bearing the risk of poor investment decisions.
There are two types of 401k: the traditional 401k and the Roth 401k. Each plan has a tax benefit and contributions are subject to penalty for early withdrawal. In a traditional 401k, employee contributions are pre-tax paycheck deductions, which allows employees to minimize their income tax obligations while saving for retirement. Contributions to a 401k are invested, often in mutual funds, where the money can grow tax-free. The money saved in a traditional 401k is subject to regular income tax requirements upon withdrawal once the individual retires. However, this money cannot be withdrawn until the individual reaches the age of seventy-two and minimum withdrawals are required or there is a penalty of fifty percent of the distribution amount. Early withdrawals beginning at age fifty-nine and a half are subject to a ten-percent penalty.
Contributions to a Roth 401k are taxed upfront, which may reduce the amount of taxes paid overall since it is the deposited money that is taxed, instead of the withdrawals that have been growing through investments before retirement. Unlike the traditional 401k, there are no required minimum distributions in retirement for Roth 401ks and because the funds are taxed upfront, the ten-percent early withdrawal penalty only applies to investment gains.
While 401k plans come with a great tax benefit, they also come with great risk. Employees are responsible for investment decisions. Risky or unwise investment moves can jeopardize the money saved and lead to a retirement account that does not provide sufficient funds to support the employee through retirement.
Read more about President Biden’s proposed 401(k) Plan
Though there is no limit to the amount of growth a 401k can experience through smart investments, there is an annual limit to the amount of money an employee can contribute to the account. The cap on 401k contributions can vary from year to year. Currently, employee contributions are capped at $19,500 annually or $26,000 which includes catch-up contributions for employees age fifty or older.
Is the pension or 401k better?
Because the pension is the only retirement option that provides guaranteed income for life in retirement, it is the preferable retirement plan. However, your future is still in good hands if your employer only provides a 401k so long as you are contributing to it and investing wisely. With a 401k, you are in control of your retirement because, in addition to deciding how much to contribute to the account and when and how to withdraw the money, you are also in charge of determining how this money should be invested to maximize the growth of your account. However, with this responsibility comes risk. It is up to you to make smart investment decisions because you will bear the loss for any detrimental investment moves.
If your employer offers a pension plan, you do not have the same privilege and responsibility for controlling your retirement investments as you would in a 401k plan. However, that also frees you from the risk of loss. A pension guarantees you will receive a set monthly income throughout retirement and the risk for bad investment decisions falls to your employer.