What Is the Difference Between a Pension and a 401(k)

a woman learning about pensions and 401(k)s

Understanding the differences and benefits between your 401(k) and pension can help you utilize your assets wisely and make them last throughout retirement. Though the two plans function differently, both can provide a savings cushion to improve your quality of life in later years. 

What Is a Pension? 

Certain companies offer employees a pension plan, which provides a guaranteed monthly payment starting at retirement and lasting the rest of their lives. Employees are often automatically enrolled in this type of investment plan when they start working for their employer.  

With this type of plan, workers must usually remain with the company for a set number of years to vest within the plan. Additionally, they must reach a certain age before payments begin.  

Employers often fund pension plans entirely, though some employers allow matching contributions by the employee. An additional benefit of a pension plan is that they often offer a spouse survivorship option. In the event the worker passes, their spouse will receive the monthly payment in their stead.  

While a fully funded pension can be seen as a positive, employees generally have no control over the types of investments that are made within the pension portfolio. That means that if the portfolio underperforms, their individual pension underperforms as well. If the company declares bankruptcy, an employee’s benefit will likely be reduced.  

With a pension plan, the employee places all investment decision-making in the hands of their employer. Additionally, there is little flexibility in tapping into your pension plan funds before retirement age. Aside from the survivorship option, employees cannot pass on benefits to their heirs upon death.  

What Is a 401(k)? 

A popular option among employer-sponsored retirement plans is the 401(k). This plan sets aside a chosen percentage of your paycheck to be invested for your retirement. Your employer may offer an outright contribution to this plan, as well as a match benefit. For example, your employer may match your contribution to the plan up to 6% of your annual salary.

The benefits of the 401(k) plan make it a desirable investment vehicle for those who want more control over their retirement income. Participants are generally given a selection of investment options to choose from, including company stock, individual stocks, and mutual funds. They control how much or how little to invest up to a government limit.  

Traditional 401k plans reduce an employee’s taxable income, often placing them in a lower tax bracket while still in the workforce. Taxes are then deferred until retirement, where a retiree will usually be in a much lower tax bracket.  

The Roth 401(k) accepts contributions with money an investor has already paid taxes on. With this type of 401(k), withdrawals can be taken tax-free, whereas, with a traditional 401(k), withdrawals will be taxed as income. Investors can begin taking withdrawals out of a 401(k) at age 59 ½ without penalty. There is a 10% penalty for taking withdrawals before that age. 

The Key Differences Between a Pension and a 401(k) 

Whether an investor has one or both of these types of retirement vehicles, it’s important to understand the difference in how they function. The key differences between a pension and a 401(k) are: 

  • An employer normally funds a pension plan, while an employee funds a 401(k). 
  • A 401(k) generally offers more investment options and access to funds. 
  • Pension plans are federally insured, while 401(k)s aren’t. 
  • You can easily roll over a 401(k) if you leave a job, while you may not be able to do the same with a pension. 

Understanding your employer’s retirement plan options is crucial to every investor’s financial journey. Investors should begin by understanding the rules of their employer’s plan, and if they fit into their investment goals and time horizon.

It’s always wise to consult with a financial professional to determine the best investment and retirement planning vehicles for you and your specific circumstances. 

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