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In a nutshell
A 401(k) is a retirement plan offered by an employer but mainly funded through contributions from an employee. In contrast, a pension plan is usually financed by the employer.
- A 401(k) plan’s value often rises and falls due to employee contributions and economic volatility.
- A pension plan is guaranteed income for the life of the retiree.
- 401(k)s have largely replaced pension plans as most employees' primary source of retirement income.
401(k) plans
Unless you work for a government entity (whether local, state or federal, or hold a union position) chances are your primary retirement plan is a 401(k). Most employers offer a 401(k) retirement plan to help employees save for retirement. Additionally, some employers match employee 401(k) contributions up to a certain percentage of the employee’s salary.
In 2024, employees can contribute up to $23,000 to their 401(k) plan, while those over 50 can contribute an additional $7,500. What’s attractive about 401(k) plans is the money you contribute is tax deferred until you make a withdrawal.
Pros:
- Easy to set up, and contributions are usually deducted from your paycheck before tax.
- You control how your money is invested, typically through mutual funds, stocks and bonds. However, your level of choice can vary depending on your employer’s plan.
- You can take your 401(k) money with you if you leave your job, either by rolling it over into an IRA or taking a cash payment.
- With some 401(k) plans, you can take a loan if you experience financial hardship.
Cons:
- Employees must contribute most of the funds.
- Your plan can lose value due to economic downturns.
- Tax penalty for early withdrawals.
- Money might not last through retirement, depending on how much you contribute.
How 401(k) plans work
A 401(k) plan places employee-contributed funds into an employer-sponsored account. These funds are then invested in mutual funds and other financial products to grow over time.
Often, employers will match employee contributions up to a specific percentage of their salary, which can help your 401(k) plans grow. When you reach retirement age or age 59 1 ⁄ 2, you can choose to take your payment in a lump-sum cashout, or receive an annuity until your death or the money in the account runs out.
Pension plans
Pension plans aren’t nearly as common as they used to be. Today, unless you’re a union employee or work for a government agency, you generally won’t be eligible for a pension plan.
Pension plans are an incentive for those looking to build a long-term career with a single company or organization. Usually, after 20 or 30 years of employment (depending on the plan) you become “fully vested” and can retire with a full pension. The pension’s total value will vary by company and years of service, but you can expect to receive a monthly payment until your death.
Pros:
- Guaranteed monthly income for your or your spouse for life.
- Your employer manages the money and investments for you.
- Your employer makes most of the contributions for you.
- Yearly raises due to economic growth.
Cons:
- You lose the pension if you change jobs.
- There is no control over investments since the employer manages the plan.
- It may not be enough for retirement, depending on how much your company invests.
- Your monthly benefit may be reduced due to company failure.
How pensions work
A pension plan is essentially a promise that your employer will pay you a monthly benefit until your death based on years of service and the average of your last five to seven years of salary when you retire. Your employer will invest funds into an account for you, allowing you the opportunity to invest your money elsewhere. Once you become “vested,” you’ll know your monthly payout, which is a great way to plan for life after retirement.
The key differences between 401(k) and pension plans
While 401(k) and pension plans are both employer-sponsored retirement plans, there are a few key differences between them:
- 401(k) plans are funded mainly through employee contributions, although some organizations may offer matching funds. Pension plans are generally employer-funded.
- Pension plans offer a monthly benefit for the life of the retiree. A 401(k) plan pays out only while money is in the account.
- Pension plans don’t usually go broke, although an organization may have financial difficulty. Organizations offering pension plans pay into an insurance fund administered by the federal government called the Pension Benefit Guaranty Corporation, which will pay the pension if a company becomes insolvent. A 401(k) plan may gain or lose value depending on fluctuations in financial markets.
- If you leave your job before retirement, you lose your pension plan. A 401(k) plan can be rolled over into an IRA or into the 401(k) offered by a new employer.
Can you have both a 401(k) and a pension plan?
It is possible to have both a pension plan and a 401(k) retirement plan. Organizations that offer employee pension plans may also provide 401(k) plans to help attract talent in tight labor markets. Another thing to consider is that a pension plan guarantees you a monthly benefit, but it might be a lot less than your monthly salary before retirement.
Combining 401(k) and pension plans
With the rising cost of health care and Americans living longer, combining a 401(k) plan with your pension plan is an excellent way to ensure you have enough money to last through retirement. The first step would be to find a job in a sector that offers a pension plan and plan to work there long enough to become vested in their retirement plan.
While it’s not common for a company to offer employees both a pension and a 401(k) plan, it does happen. Combining the two is an excellent way to build your retirement portfolio and ensure you have enough money to enjoy life after you stop working.
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Benefits
- Find your old 401(k)s, 403(b)s
- Find 401(k)s hidden fees
- Rollover to better retirement accounts
- Unlock old 401(k)/IRA accounts
What are the tax implications of withdrawing from your 401(k) or pension plan?
The money you contribute to a 401(k) is tax-free until you withdraw it. If you are younger than 59½, you’ll probably pay a 10% penalty fee, as well as the taxes that were initially deferred, which depend on your income that year.
For example, if you want to withdraw $5,000 from your 401(k) early, the 10% early withdrawal penalty would be $500. If this is the only money you “earn” in the year, you’ll also pay 20% tax on it (and more if you earn more). This penalty would be $1,000, meaning you’ll clear $3,500. Unless you’re experiencing financial hardship, finding money elsewhere is almost always better than raiding your 401(k).
What are the alternatives to either 401(k)s or pension plans?
If your current employer doesn’t offer a pension or access to a 401(k) plan, there are still ways for you to save for retirement.
Traditional IRA
A traditional IRA allows you to contribute funds into an account and then take a deduction on your taxes. Any earnings you make on the account won’t be taxed until you make a withdrawal. For 2024, the IRA allows contributions up to $7,000 for those under age 49, or $8,000 for those age 50 and above.
Roth IRA
A Roth IRA is funded using after-tax dollars, so you do not receive a tax deduction when filing your taxes. However, the earnings grow tax-free, and withdrawals after age 59½ are also tax-free. The contribution limits are the same as a traditional IRA for 2024. Essentially, you pay your taxes upfront.
SEP IRA
Small business owners can still save for retirement by taking advantage of the simplified employee pension (SEP) IRA. Like a traditional IRA, small business owners and the self-employed can contribute to a SEP IRA to help them save for retirement. The contribution limits are higher for this type of IRA. For 2024, the limit is $69,000, or 25% of eligible compensation, whichever is smaller.
There are rules and regulations regarding the setting up of these IRAs, so be sure to speak with a tax professional if you have questions about the process.
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Both pension plans and 401(k)s can help you save for retirement, but there are some key differences between them. Even if you’re fortunate enough to qualify for a company pension, don’t let that be your only source of retirement income because it may not be enough to let you live comfortably. Take advantage of 401(k) plan opportunities sponsored through your employer, or look into a traditional or Roth IRA and contribute the maximum each year.
Frequently asked questions (FAQs)
Are pensions guaranteed for life?
Pensions are generally guaranteed for life. Depending on the pension type, whether a single-life or joint-life, your pension could continue to be paid to your beneficiary upon your death. Some pension plan payouts can be reduced if you select a joint-life payment plan to offset costs.
What happens to your pension if you quit?
If you stop working for an employer who offers a pension plan in retirement, you may not receive any of those benefits when you retire. However, some organizations, mainly government agencies, offer reduced benefits if specific criteria are met when you leave your position.
How many years does it take to be vested in a pension plan?
The years it takes to become vested in a pension plan depend on the organization offering it. Although it varies widely, employees can generally expect to be vested with their company after five to 10 years of service.
Can you cash out a pension plan?
Some companies offer employee buyouts when looking to downsize their workforce. Employees can also opt to take early retirement, where they can receive a lump-sum payment. If an employee leaves before they become vested, they are generally unable to cash out a pension plan.
This content is created by AP Buyline in accordance with AP’s editorial guidelines and supervised and edited by AP staff. Our evaluations and opinions are not influenced by our advertising relationships, but we may earn commissions from our partners’ links in this content. Learn more about AP Buyline here.
