A 401(k) plan is a retirement plan in which employees contribute to a tax-deferred account via paycheck deductions (and often with an employer match). A pension plan is a different kind of retirement plan, in which a company sets money aside to give to future retirees.
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. While both a 401(k) plan and a pension plan are employer-sponsored retirement plants, there are some significant differences between the two.
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 401k—or, a 401k vs pension.
How are 401(k) Plans Different from Pension Plans?
Pension plans and 401(k) plans are both valuable employee retirement benefits. The first step to making the most of an employer retirement plan is understanding the differences between them.
Employees typically fund 401(k) plans, while employers typically fund pension plans.
Employees can choose investments (from several options) in their 401(k), while employers choose the investments that fund a pension plan.
The value of a 401(k) plan at retirement depends on the performance of the investments when the employee retirees. Pensions, on the other hand, guarantee a set amount of income for life.
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 directs 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 $245,000 for 2022 ($230,000 for 2021).
• 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.
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When it comes to pension plan withdrawals, employees who take out funds before the age of 59 ½ must pay a 10% early withdrawal penalty as well as standard income taxes. This is similar to the penalties and taxes associated with early withdrawal from a traditional 401(k) plan.
Pension Plan Advantages
The main advantage for employees in pension plans 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:
IRS-qualified pension plans provide tax benefits to contributors, whether employers or employees. In many instances, contributions occur with pre-tax dollars.
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 is interest earned on the initial investment as well as on subsequent interest, 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.
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 than manually transferring funds into a separate account.
What Is a 401(k) and How Does It Work?
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. They can typically choose from an array of offerings from the employer and include 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”).
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401 (k) Contribution Limits
To account for inflation, the IRS periodically adjusts the maximum amount an employer or employee can contribute to a 401(k) plan.
• For 2022, annual employee-only contributions can’t exceed $20,500 for workers under 50, and $27,000 for workers over 50 (this includes a $6,500 catch-up contribution).
• The total annual contribution paid by employer and employee in 2022 is capped at 100% of compensation or $61,000 for workers under 50, $67,500 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.
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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 the investment strategy, 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.
One of the biggest benefits of participating in a 401(k) plan is the tax savings. Contributions to a 401(k) come from pre-tax dollars through payroll deductions, 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.
Many 401(k) plan participants are eligible for an employer match up to a certain amount, which essentially means free money.
Why Did 401(k) Plans Largely Replace Pension Plans?
The percentage of private sector employees whose only retirement account is a defined benefit pension plan is just 3% 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 still needs to distribute 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 US taxpayers.
To avoid situations like this, many of today’s employers have shifted the burden of retirement funding to their workers.
401(k) vs. Pension: Which Is Better?
When considering a pension versus a 401k, 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?
Yes. 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 after becoming eligible for a pension and opens a 401(k) with a new employer, their previous employer will still maintain their pension, though the employer will no longer pay into the 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 you can use to save for retirement. One major benefit of an IRA 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 and offer significant tax advantages. 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 401(k) limits. For 2021 & 2022, 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.
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Pension plans are employer-sponsored, employer-funded retirement plans that guarantee a set income to participants for life. On the other hand, 401(k) accounts are employer-sponsored retirement plans through which employees make their own investment decisions and, in some cases, receive 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, as long as you stayed with your company long enough for your benefits to vest.
Some people 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. IRAs 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. You can use the account to open an IRA and start investing in stocks, exchange-traded funds, and other types of investments.
Photo credit: iStock/Sam Edwards
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