There are many different financial plans that can help you save for a comfortable retirement. However, since all retirement plans have their own features and benefits, it's not always easy to know which one to select. That's why it's best to compare as many of the different plans as possible in order to make the right choice for you.
In this article, we're going to focus on what pensions and 401(k)s are, as well as the key differences between the two.
What is a pension plan?
A pension plan (also referred to as a defined benefit plan) is a retirement account that is sponsored and funded by your employer. It's based on a formula that includes factors such as your salary, age, and the number of years you have worked at your company. For example, your pension benefit might be equal to 1% of your average salary for the last five years of employment, and then times your total years of service.1 Over the years, your employer makes contributions on your behalf and promises to make you regular, predetermined payouts every month when you retire.
What is a 401(k) plan?
A 401(k) plan is retirement account that's made available to employees who wish to save for their retirement (provided their employer offers a plan). In this case, it's the employer that holds back a part of your salary (tax-deferred) and places it into a fund that you'll receive when you retire. Some employers are even willing to match the contributions made by their employees with their own money. Since 401(k) plans are meant to encourage you to save for retirement, there are heavy tax penalties imposed for early withdrawals (before age 59½).
What's the difference between a pension plan and a 401(k) plan?
A pension plan is funded by the employer, while a 401(k) is funded by the employee. (Some employers will match a portion of your 401(k) contributions.)
A 401(k) allows you control over your fund contributions, a pension plan does not.
Pension plans guarantee a monthly check in retirement a 401(k) does not offer guarantees.
Pension plans have been in existence for a long time, while 401(k)s are gaining in popularity. In fact, the 401(k) will most likely be replacing pension plans all together in the near future.2 However, there are still employers who offer both a pension plan and a 401(k) plan — if you're lucky enough to be in that fortunate situation.