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What Is The Difference Between a Pension and 401(k) Plan?

December 07, 2020 · 7 minute read

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What Is The Difference Between a Pension and 401(k) Plan?

Over the past few decades, defined-contribution retirement plans like the 401(k) have steadily replaced pension plans as the private-sector, employer-sponsored retirement plan of choice, and there are several reasons why. Still, for employees who are able to receive this increasingly rare work benefit, it can be a welcome part of an overall retirement plan.

Pension plans differ from 401(k) plans in a few main ways. Whereas 401(k) plans are funded primarily by employees (with an employer match benefit in some cases), who also get to choose their investment allocation, pension plans are funded primarily by employers, who choose the investments.

Another key difference: The balance of a 401(k)s depends on the performance of the investments when the employee withdraws the funds. Pensions, on the other hand, guarantee a set amount of income for life.

Let’s take a deeper look at the difference between pension and 401(k) plans, the advantages and disadvantages of each, and how companies decide to offer a pension vs. 401(k)—or, a 401(k) vs pension.

What Is a Pension and How Does it Work?

A pension plan is a type of retirement savings plan where an employer contributes funds to an investment account on behalf of their employees. The earnings become income for the employees once they retire.

There are two common types of pension plans:

•   Defined-benefit pension plans, also known as traditional pension plans, are employer-sponsored retirement investment plans that guarantee the employee will receive a set benefit amount upon retirement (usually calculated with set parameters, i.e. employee earnings and years of service). Regardless of how the investment pool performs, the employer is responsible for directing pension payments to the retired employee. If the plan assets aren’t enough to pay out to the employee, the employer is on the hook for the rest of the money.

According to the IRS, contributions to a defined-benefit pension plan cannot exceed 100% of the employee’s average compensation for the highest three consecutive calendar years of their employment or $230,000 (for 2020).

•   Defined-contribution pension plans are employer-sponsored retirement plans to which employers make plan contributions on their employee’s behalf and the benefit the employee receives is based solely on the performance of the investment pool. Like 401(k) plans, employees can contribute to these plans, and in some cases, employers match the contribution made by the employee. Unlike defined benefit pension plans, however, the employee is not guaranteed a certain amount of money upon retirement.

When it comes to pension plan withdrawals, employees who take out funds before the age of 59 ½ are subject to a 10% early withdrawal penalty as well as the standard income tax that is due upon any defined contribution plan withdrawal. This is similar to the penalties and taxes associated with early withdrawal from a 401(k) plan.

Pension Plan Advantages

For employees who are enrolled in defined-benefit pension plans, the main advantage is that this is extra retirement income from your employer. An employee does not need to contribute to a defined-benefit pension plan in order to start receiving consistent payouts upon retirement.

Other advantages of pension plans include:

•   Payroll deduction savings: Much like 401(k) contributions, defined-contribution pension plan contributions are withheld directly from an employee’s pay. This makes it simpler and more straightforward to save money for retirement without manually transferring funds into a separate account.
•   Tax savings: IRS-qualified pension plans provide tax benefits to contributors, whether employers or employees. In many instances, contributions are made with pre-tax dollars, so tax deductibility isn’t even a factor.
•   Higher contribution limits: When compared to 401(k)s, defined-benefit pension plans have significantly higher contribution limits and, as such, present an opportunity to set aside more money for retirement.
•   Compound interest: Compound interest is interest earned on the initial investment, which accumulates over time. The sooner a person starts investing in a pension plan, the more they can benefit from compounding interest.
•   Decreased market risk: The market risk for a pension vs. 401(k) is significantly lower because a defined-benefit pension plan means a guarantee of lifetime income.

How is a 401(k) Different from a Pension?

A traditional 401(k) plan is a tax-advantaged defined-contribution plan where workers contribute pre-tax dollars to the investment account via automatic payroll deductions. These contributions are sometimes fully or partially matched by their employers, and the investment earnings are not taxed until the employee reaches the retirement age of 59 ½.

With a 401(k), employees and employers may both make contributions to the account (up to a certain IRS-established limit), but employees are responsible for selecting the specific investments. Their selection is based on an array of offerings from the employer and includes a mixture of stocks and bonds that vary in levels of risk depending on when they plan to retire.

The IRS considers the removal of any 401(k) funds before the age of 59 ½ an “early withdrawal.” The penalty for removing funds before that time is an additional income tax of 10% of the withdrawal amount (there are exceptions, notably a hardship distribution, where plan participants can withdraw funds early to cover “immediate and heavy financial need”).

401 (k) Contribution Limits

To account for inflation, the maximum amount an employer or employee can contribute to a 401(k) plan is adjusted periodically.

•   For 2020, annual employee-only contributions can’t exceed $19,500 for workers under 50, and $26,000 for workers over 50 (this includes a $6,500 catch-up contribution ).
•   The total annual contribution paid by employer and employee is capped at $57,000 for workers under 50, $63,500 for workers over 50, or 100% of employee compensation—whichever is less.

Some plans allow employees to make additional after-tax contributions to their 401(k) plan, within the contribution limits outlined above.

401(k) Plan Advantages

While a 401(k) plan might not offer as clearly-defined a retirement savings picture as a pension plan, it still comes with a number of upsides for participants who want a more active role in their retirement investments.

•   Self-directed investment opportunities: Unlike employer-directed pension plans, in which the employee has no say in how the money is invested, 401(k) plans offer participants more control over how much they invest and where the money goes (within parameters set by their employer). Plans typically offer a selection of investment options, including mutual funds, individual stocks and bonds, Exchange Traded Funds (ETFs), and non-traditional assets like real estate.
•   Tax advantages: One of the biggest benefits of participating in a 401(k) plan is the tax savings. 401(k) contributions are made from pre-tax dollars through payroll deduction, reducing the gross income of the participant and allowing them to pay less in income taxes overall. Also, 401(k) plan participants don’t pay taxes on their gains, so they can grow even more money over time.
•   Employer matching: Many 401(k) plan participants are eligible for an employer match up to a certain amount, which essentially means free money.

The IRS considers the removal of any 401(k) funds before the age of 59 ½ an “early withdrawal.” The penalty for removing funds before that time is an additional income tax of 10% of the withdrawal amount (there are exceptions, notably a hardship distribution, where plan participants can withdraw funds early to cover “immediate and heavy financial need”).

Why Did 401(k) Plans Replace Pension Plans?

The percentage of private sector employees whose only retirement account is a defined benefit pension plan is just 4% today, versus 60% in the early 1980s. The majority of private sector companies stopped funding traditional pension plans in the last few decades, freezing the plans and shifting to defined-contribution plans like 401(k)s.

When a pension fund isn’t full enough to distribute promised payouts, the company needs to buck up that money to plan participants. In several instances in recent decades, pension fund deficits for large enterprises like airlines and steel makers were so enormous they required government bailouts. Upon filing for bankruptcy, these employers forfeited responsibility for their retirement plan obligations and shifted the burden to U.S. taxpayers.

To avoid situations like this, many of today’s employers are asking employees to take control of their own retirement planning, and offering 401(k) plans instead.

401(k) vs. Pension: Which Is Better?

If it comes down to knowing exactly what to expect when cashing out their retirement plans, most people prefer the certainty that comes with a pension plan.

But for those who seek more control over their retirement savings and more investment vehicles to choose from, a 401(k) plan could be the more advantageous option.

In the case of the 401(k), it really depends on how well the investments perform over time. Without the safety net of guaranteed income that comes with a pension plan, a poorly performing 401(k) plan has a direct effect on a retiree’s nest egg.

Can You Have a Pension Plan and a 401(k) Plan?

A person can have both a pension plan and a 401(k) plan, but usually not from the same employer. If an employee leaves a company that offered a pension and opens a 401(k) with a new employer, their pension will still be fully-directed by the previous employer, though the employer will no longer pay into that account. An employee can still access their former retirement account linked to the previous employer in order to use pension funds.

Beyond Employer-Sponsored Plans: The IRA

A traditional Individual Retirement Account, or IRA, is another tax-advantaged investment option that can be used for retirement saving. One major benefit of an IRA vs. a 401(k) is that anyone can set up an IRA, whether they’re self-employed, work part time, or already have a 401(k) with an employer and want to save extra retirement funds.

IRAs have a larger investment selection, offer significant tax advantages, and, in the case of Roth IRAs, there are no penalties for withdrawing funds before the age of 59 ½.

The only catch, of course, is that with an IRA there is no employer to offer matching contributions. In addition, the contribution limits are lower than they are for 401(k)s. For 2020, contributions to traditional IRA plans are capped at $6,000 for individuals under age 50, and $7,000 (using catch-up contributions) for people over age 50.

The Takeaway

Pension plans are employer-sponsored, employer-funded retirement plans that guarantee a set income to participants for life.

401(k) plans, on the other hand, are employer-sponsored retirement plans that direct employees to make their own investment decisions and, in some cases, offer an employer match in funds. The post-retirement payout varies depending on market fluctuations.

While pension plans are far more rare today than they were 30 years ago, if you have worked at a company that offers one, that money will still come to you after retirement even if you change jobs.

Some people are lucky enough to have both pensions and 401(k) plans, but there are other ways to take an active role in saving for retirement. An IRA is an alternative to 401(k) and pension plans that allows anyone to open a retirement savings account, regardless of their employment status. They have lower contribution limits but a larger selection of investments to choose from.

An online retirement account with SoFi Invest® puts you in the driver’s seat by helping you set your goals, diversify your portfolio and get solid advice every step of the way.

Find out how SoFi Invest® can help with your personal retirement goals.

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