Q&A: What's the Difference Between a Pension and 401(k)?
By Indeed Editorial Team
Updated August 25, 2021
Published December 12, 2019
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
When it comes to choosing a retirement plan for employees, companies typically decide between offering a pension vs. a 401(k). While both benefit plans provide retirement income, there are some key differences between them: A pension is a defined benefit plan that guarantees retirees a specific monthly income, while a 401(k) plan is a defined contribution plan that depends on how much you (and your employer) choose to contribute and invest.
This article explains in more detail how these two retirement plans work and presents the main differences between a pension and a 401(k).
What is a pension plan?
A pension plan is a form of retirement plan in which the employee contributes money–usually from their salary–to a fund that the employer also contributes to. The value of the contribution is determined by a number of factors, such as how long the employee has worked for the company, yearly income and when they will retire.
The majority of pension plans are taxable, and the tax percentage may differ according to contribution level, place of residence and employer’s contribution level.
What is a 401(k) plan?
A 401(k) plan is a company-sponsored retirement plan that enables employees to contribute a portion of their salary to a retirement account that can earn interest tax-deferred. Tax-deferred refers to the saved income that is not taxable until it is withdrawn at the age of 65.
One key difference between the two retirement options is that with a 401(k), there can be heavier penalties for withdrawing your funds earlier than 65 years of age.
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Key differences between a pension plan and a 401(k)
There are several key differences between a pension plan and a 401(k) plan. The following list highlights these aspects and offers insight into the processes involved with contributing to both retirement options:
Control of investments
Setting the contribution level
One of the more common differences between a 401(k) and a pension plan is how the contribution level is set. When you have a 401(k), you may choose the amount to contribute to each paycheck. There is an annual contribution limit, however, and you might research your state’s requirements to be certain that you stay within the yearly limit.
Conversely, when you have a pension, your employer is in charge of the contribution decisions. This can be beneficial as it offers consistent funding amounts and sets limits. If, however, funding fails for an organization’s pension program, there can be minimal to no coverage.
In order to plan how much to contribute to your retirement, you may assess your income level, how much you can afford to contribute and whether there are any minimum limits.
Vesting is a term that refers to when the employee can collect accrued retirement benefits.
Oftentimes, a 410(k) plan may be subject to vesting. Any money that is distributed into the 401(k) is fully vested, so in the event you leave your position in the future, the money that you have vested remains yours.
When you have a pension, the benefits can depend on how long you were with the company and your salary level. After evaluating these two factors, the pension plan can be subject to graded vesting or cliff vesting.
Cliff vesting happens when you stay with the business for a specific length of time, which can oftentimes be a minimum of five years. After that, you have full access to your pension benefits.
Graded vesting is different, as you may only have access to your pension benefits at a rate of 20 percent annually, and only after you have worked in the company for a minimum of three years. Additionally, after seven years of employment within the company, you can be eligible to receive all of your pension.
Protection benefits also differ between both pension and 401(k) plans. Protection benefits are benefits awarded in the event the contributing company fails either through bankruptcy or lack of funding. With a pension plan and the company’s contribution levels towards it, there can be limited protection, as employers commonly have equal or greater contribution levels over the funds in the pension than employees and staff do.
However, with a 401K, employers are uninvolved with your yearly contributions. The funds in your 401(k) belong to you and no one else, so even if the company fails, you are still able to access your full benefits.
Control of investments
With a pension plan, employees may have little control over investment decisions. This can be a benefit in some cases, where entry-level employees are still developing their knowledge of navigating investments and diversification. The drawback, however, can be the potential of an employer’s poor investment strategies.
With a 401(k), you can have full control of your investment options. As an advantageous perspective, this can allow you to choose your own investment methods, diversify your funds how you see fit and control when you pull out of investments or add more funds.
Another important difference between pension plans and 401(k)s is the ability to manage your money. Pensions are not commonly transferred if you transition between jobs. Typically, you may choose to receive a lump sum when you retire or leave a position, monthly payments or rollover your pension into an Individual Retirement Account (IRA).
A 401(k) may also be managed as one lump sum, in monthly payments or transferred to an IRA. You may choose to transfer your 401(k) over to a new account if you transfer jobs or switch careers.
Borrowing from pensions versus 401(k)s also presents differences. For instance, If you have a pension, the funds may not be accessible before retirement. Conversely, a 401(k) plan may allow you to borrow up to 50% of your contributions.
There can be exceptions to both of these plans, though. For example, if you want to purchase a home, there are loan and borrowing options available for both pensions and 401(k)s. Depending on the company you work for and the retirement plan you currently have, you may consider researching your borrowing options in the event you plan to buy a new house.
While both pension plans and 401(k)s have their differences, it is up to the employer to choose which one they’ll offer to their employees.
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