One of the biggest trends in retirement planning over the past few decades has been the shift from defined benefit pension plans to defined contribution plans like 401(k) plans. Employers make contributions to pension plans, while employees make contributions to 401(k) plans. Learn more about the differences between these two options.
What is the difference between a pension plan and a 401(k) plan?
Pension plan
The employer provides funding
The employee provides funding; the employer may match
The employer decides how to invest the money
The employee decides how to invest the money
Guarantees that if the fund is terminated or mismanaged, participants receive the money
No guarantee of income
Contributions
A pension plan is a plan offered by the employer where the benefits for the employee are calculated using a formula that considers factors such as length of service and salary history. With pension plans, the employer puts money into the plan while you work.
Participants contribute to a 401(k) plan. Employers may match employee contributions, but they are not required to do so. If the employer matches contributions, the decision to participate is an easy one.
Note: Consider matched dollars as a bonus you receive in each pay period. Try to contribute at least enough to get the maximum match from your employer.
Investment Options
With a pension plan, the plan sponsor decides how to invest retirement funds.
With a 401(k) plan, you determine how to invest the money. Typically, you have several investment options to choose from. One common trend in retirement plans is to provide a comprehensive approach to diversifying investments through target-date funds. A 401(k) plan sponsor may also offer professional investment guidance.
Plan Termination
If you work for an employer that offers a pension plan, it’s important to realize that they can choose to terminate the plan. In the event your pension plan is terminated, your accrued benefits typically become frozen. In this scenario, you’ll receive the benefits earned up to that point, but you won’t accrue any additional service credit.
Pension plans have been mismanaged in the past and have been unable to pay all promised benefits to participants. If a pension plan is covered by the Pension Benefit Guaranty Corporation (PBGC), some benefits are protected for pension plan participants.
Employers can also terminate 401(k) plans. If the plan is terminated, all accrued benefits are vested, meaning they belong entirely to you. Employers must distribute the assets as quickly as possible, and you can roll over the distributed funds into another qualified plan like an Individual Retirement Account (IRA).
Income
Pension plans provide guaranteed income, and all investment risk is placed on the plan sponsor. Although the popularity of defined benefit pension plans has declined in recent years, they remain the most common model for defined benefit plans.
Your retirement income depends on your contributions, your employer’s contribution (if available), and your investment performance.
Other Features of 401(k) Plans
401(k) plans set a limit on how much you can contribute each year. You can contribute a maximum of $20,500 in 2022 (up from $19,500 in 2021), plus an additional $6,500 if you are age 50 or older. If contributions are made with pre-tax dollars, you can reduce your final tax bill for the year by hundreds or thousands of dollars.
Your money continues to grow and is tax-protected until you withdraw it. You can withdraw funds without early withdrawal penalties if you become disabled, reach age 59 and a half, or experience financial hardship. You must take a distribution after reaching age 72.
Conclusion
Advantage
The retirement plan is to provide guaranteed income. The fewest number of companies offer retirement plans compared to previous generations. This means that the burden of saving for retirement falls on you as an individual. As a result, you need to know how to save enough to create an income similar to your own retirement upon leaving work.
To ensure you are on the right track, calculate your basic retirement needs at least once a year. There are a variety of different retirement calculators these days to help you run a simple retirement calculation to see if you are on the right path.
Source: https://www.thebalancemoney.com/how-is-a-401-k-different-from-a-pension-4171909
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