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Understanding the different retirement savings vehicles is a tall order. Thankfully, I'm here to clear up your burning questions, like what's the difference between a 401(k) and a pension plan?
The difference between a 401(k) and a pension plan is that a 401(k) is a savings account, and a pension plan is a benefit plan that pays employees a regular benefit after retirement. A 401(k) is a defined-contribution plan, whereas a pension plan is a defined-benefit plan.
I know you're still hunting for more clarification; no worries! In the rest of this article, I'll dive deeper into the specifics around 401(k)s and pension plans, so you can better understand the difference.
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What Are 401(k)'s?
401(k)s are employer-sponsored defined-contribution plans. Employers often make matching contributions towards a portion of an employee's 401(k), but the employee bears the investment risk.
Usually, a fixed dollar amount or percent of an employee's income will automatically deposit into their 401(k). 401(k)s are tax-deferred, which means the employee does not pay taxes on their 401(k) earnings until funds are withdrawn from the account.
The trifecta of employer matching, automatic deposits, and tax-deferred savings make 401(k)s an effective saving strategy for employees.
What Are Pension Plans?
Pension plans are set payments that an employer pays to an employee after retirement. Pension plans move the investment risk off the employee and onto the employer.
It's common for employers to hire an outside investment manager to manage a pension plan account. By hiring an outside investment manager, the employer alleviates the burden of risk.
The amount per pension plan payment is derived based on length of employment and annual salary. Usually, employees know the amount they will receive from their pension before retirement.
401(k) vs. Pension Plans: Which is Better for You?
Pension plans are better than 401(k)s for a few reasons; pension plans take the investment risk off the employee and give employees a guaranteed fixed retirement income, and don't require as much and sometimes any employee contributions.
Despite employees preferring pension plans over 401(k)s, fewer and fewer companies give out pensions each year. According to Investopedia, 14% of Fortune 500 companies offered new employees a pension plan in 2019.
Meanwhile, 59% of Fortune 500 companies provided new employees with a pension plan in 1999.
The Case for 401(k)s
While employees usually prefer pension plans, there are some notches on the scoreboard for 401(k)s. The primary advantage of a 401(k) is the flexibility to withdraw funds.
Pension plans are paid out on a fixed schedule, starting on a fixed date. When it comes to a 401(k), the employee can withdraw funds from their 401(k) at any time, as long as they're willing to take the tax hit.
Let me present a real-world example:
If an employee wants to make a large purchase, like a house, they can use their 401(k) savings to fund their downpayment. If the same employee had a pension plan, they would not be able to use any of the funds from their savings to come up with a downpayment until retirement.
Additionally, financially savvy employees may opt for a 401(k) because they want control over the investment portfolio. According to SmartAsset, the average 401(k) return is between 5% and 8% annually.
Both pension plans and 401(k)s have pros and cons. However, pension plans take the burden of investment risk off the employee, which most people prefer.
Even though pension plans are the preferred method of retirement saving for most people, the best way to save would be to have a pension and a 401(k) combination.
With a pension and 401(k) combination, you can enjoy 401(k) flexibility with pension stability.
401(k) vs. Pension FAQ's
You can have a pension plan and a 401(k) as long as your employer provides both. You can also invest in an independent investment account (IRA) simultaneously as a 401(k) and a pension plan.
An IRA is another way to defer taxes on investments until retirement.
The advantage of tax-deferred savings is that it allows you to delay paying tax on your investments until retirement. Retirees tend to have a lower income than they do during their career, so by pushing off taxes till retirement, you'll pay a lower tax percent on your savings.
Tax-deferred savings accounts are best for high-income individuals. There is a better option for low-income earners called tax-exempt saving accounts.
Tax-exempt saving accounts are accounts where the contributor pays the tax upfront and contributes after-tax dollars. The two well-known tax-exempt saving accounts in the United States are the Roth IRA and the Roth 401(k).
Tax-exempt savings accounts are ideal for low-income individuals, like students and entry-level employees. Tax-exempt accounts are best for young people with a low income because they are likely in the lowest tax bracket they'll be in for the foreseeable future.
Therefore, if they were to invest into a tax-deferred savings account and withdraw the funds later on when they're in a higher tax bracket, the investor will pay more in taxes.
I'll use another real-world example to explain the concept better: Say you invest $100 in a tax-deferred savings account right out of college when you're in a 10% tax bracket.
After your initial deposit, you let the money sit in your account for 20 years. Twenty years later, you're a high-income investment advisor in a 32% tax bracket.
You decide to withdraw your initial $100 from your tax-deferred account. Unfortunately, you will now have to pay a 32% tax on your investment.
Had you invested into a tax-exempt savings account, you would have only paid a 10% tax when investing your money, netting you a cool $22 profit because of your smart investing!
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