Pension Vs. 401(k): What Are The Key Differences?

There are many different ways to save for retirement, and pros and cons to each method of retirement planning. While anyone can open an Individual Retirement Account (IRA), many companies offer employer-sponsored retirement accounts. Pensions and 401(k) accounts are both ways that can help with planning for retirement, even though the two plan types have key differences. Understanding the differences between pensions and 401(k) accounts can help you decide which plan is right for you.

What Is A Pension Plan?

A pension plan is a type of retirement plan that is sponsored by an employer and typically completely funded by the company as an employee benefit. While pension plans were very common decades ago, they have become much less common over time, as many companies have shifted to other types of retirement benefits.

With a pension plan, the company funds a certain amount each year for each qualified employee. Then, the money inside the pension plan is invested, and the proceeds are used to pay out to qualified retirees. With most pension plans, you can either take a lump sum or monthly payments over time.

Pros Of Pensions

Here are a few of the advantages of a pension plan:

• Contributions: Typically your employer makes contributions to a pension plan as an employee benefit. That means you won't have to pay of pocket to make contributions.
• Benefits are fixed: Your pension benefits are fixed, usually based on your salary and your years of service. That takes some of the guesswork out of knowing how much to save for retirement.
• Investment risk: A pension is a defined-benefit type of retirement plan. That means the employer takes all of the investment risk that comes with a pension plan.

Cons Of Pensions

In contrast, a pension plan also comes with a few disadvantages:

• No control: Unlike with some other retirement plans, with a pension you don't have any control or access to your money until you retire. The company selects the investment and controls what type of investment return is offered.
• Risk of bankruptcy: You do run some risk if the company that holds your pension goes bankrupt. While there are federal programs that guarantee some pension benefits, you may still have some risk.
• Lack of accessibility: Unlike a 401(k), you have no way to access your pension funds until you retire. Even if you leave the employer, you can't rollover your funds like you could with a 401(k)

What Is A 401(k)?

A 401(k) is a different type of retirement savings plan that provides more flexibility in how you can invest and access your money. A 401(k) account is also an employer-sponsored benefit, which means that you'll enroll through your employer. With a 401(k), the burden for contributing falls on the employee, which means that you'll need to make contributions directly to your account. However, some employers do also contribute or match employee contributions up to a certain amount as an additional benefit.

As you make contributions to your 401(k) account, you may receive a tax break for contributing. When you contribute to a Traditional 401(k), the amount you contribute is not considered part of your taxable income. And if you contribute to a Roth 401(k), your contributions are made with after-tax income so your money will grow tax-free and you won't pay income tax on your withdrawals. 401(k) accounts are intended for retirement, which means that if you cash out a 401(k) before you reach retirement age, you may owe taxes or penalties, unless you roll it over into another qualified account.

Pros Of 401(k)s

Here are a few of the benefits of 401(k)s:

• Tax breaks: You are likely to get a tax break by contributing to a 401(k). Depending on the type of account that you have, you may get a tax deduction when you contribute or gain the ability to have your money grow tax-free.
• Employer matching: Many employers offer matching contributions to their employees' 401(k) accounts. This can be "free money" helping you save for retirement.
• Creditor protection: A 401(k) account is typically shielded from creditors if you file bankruptcy.

Cons Of 401(k)s

Here are some of the disadvantages of 401(k) accounts:

• Contributions: As the employee, you are responsible for making contributions to your account.
• Contribution limits: Unlike some other types of accounts, there is an IRS-mandated limit for how much you can contribute to your 401(k) account each year.
• Mandatory withdrawals: The IRS requires that you make required minimum distributions (RMDs) once you reach a certain age.

5 Differences Between Pension And 401(k) Plans

While pensions and 401(k) plans are both ways to save for retirement, there are a few important differences between pensions and 401(k) accounts.

1. Plan Eligibility

Both pension and 401(k) retirement plans are considered employer benefits. That means that you'll only be eligible based on the criteria set up by your employer. In fact, some employers may not offer a 401(k) or a pension. Your company may have certain criteria in place to determine how long you have to be working at the company to receive benefits from either plan.

2. Account Contributions

One of the main differences between pension and 401(k) retirement plans is who is responsible for contributing to the account. Generally speaking, an employee is responsible for contributing to their own 401(k) account, while an employer will fund a pension plan. However, many employers do offer matching or discretionary contributions to their employees' 401(k) accounts, as an additional employee benefit.

3. Control Over Investments

Another difference between pension and 401(k) retirement plans is the control over how the money in the account is invested. Pensions are typically controlled by the employer and employees generally do not have any control over how their funds are invested. In a 401(k) account, the employer usually has various types of investments available, and employees can choose between those investments.

4. Flexibility When Leaving A Job

Pensions and 401(k) retirement plans are treated differently when you leave your employer. You can transfer their 401(k) to your new employer's 401(k) plan or roll it over into an IRA. With a pension, control over the funds remains with the employer. That means that you may not be able to access the funds in your pension until you reach retirement age, even if you leave the company.

5. Retirement Stability

Both pensions and 401(k) retirement plans can work as a way to save more money for retirement. Pensions are generally thought to have greater stability, since they provide a set monthly payment for life. However, that stability comes with a tradeoff as pensions may have lower overall investment returns.

401(k) Vs. Pension: Which Is A Better Option?

Determining whether a 401(k) or a pension plan is a better retirement savings option will depend on your specific financial goals. In most cases, it will largely depend on your employer and what types of retirement benefits they offer. If your employer only offers one of the two, then you'll likely be stuck with the option that they provide. If you do have the option to choose between a pension or a 401(k) plan, examine the pros and cons of each and consult a financial advisor.

Alternatives To Pension And 401(k) Accounts

There are a few other retirement plans to consider for those who don’t have access to a 401(k) or pension plan through an employer. One of the most popular is an Individual Retirement Account (IRA). There are both Traditional IRAs and Roth IRAs, and both types of IRAs give different kinds of tax breaks and other benefits. Opening an IRA is something that you can do on your own without needing to go through your employer, and it gives you additional control over your money.

Pension Plan Vs. 401(k) FAQs

Can I open both a pension plan and a 401(k)?

Yes, you can have both a pension plan and a 401(k) account, but it will depend on what your employer offers. Because these are both employer-sponsored retirement plans, it's up to each employer to decide what type of plan they offer.

Can I withdraw funds early from a 401(k) and a pension?

Generally you will not have access to funds in your pension until you reach retirement age. You can withdraw funds from a 401(k) in some cases, but you may have early withdrawal penalties.

Is a pension plan better than a 401(k), or vice versa?

Both pensions and 401(k) accounts come with advantages and disadvantages, and it isn't the case that one is necessarily better than the other. Instead, look at the pros and cons of both to decide which choice may be right for you. Consider talking with your trusted friends, family or financial advisors to help decide between a pension and a 401(k).

The Bottom Line: 401(k)s And Pensions Can Both Help You Save For Retirement

Pensions and 401(k) plans are two different ways to save for retirement. Both pensions and 401(k) plans are considered employer-sponsored plans, which means that you need to enroll through your current employer. Taking advantage of one or both of these retirement plans can help put you on the path to a solid financial future. Another way to strengthen your financial picture is to use the Rocket Money℠ mobile app to track retirement investments and monitor net worth growth over time. Downloading the Rocket Money app today!