Retirement Planning

What’s The Difference between a Pension and a Retirement Plan?

Two of the most common types of retirement plans that people are familiar with are a pension and a 401k. While both of these retirement plans help you save for your future, there are a few key differences. Read on to understand the difference between a pension vs a 401k.

Pension vs. 401k - What's the Difference?

These days, it seems that everything you read or see on television has something about saving more for retirement. It's not that saving for life after your paycheck stops is anything new, but that we're having to do more with less, and take retirement planning in our own hands. 

The fact is, most of our parents had this whole retirement thing in the bag by leaving it up to their employers to figure out how to pay for their retirement via the pension plan. Today, with fewer employers offering pension plans, most of us are having to look into other alternatives in order to stash away more of what we'll need for a comfortable retirement. 

What's the difference between a pension and a retirement plan?

So what's the difference between a pension and a retirement plan? Actually, a pension is a type of retirement plan. It works differently from a 401(k)in that contributions are entirely funded and invested by your employer on your behalf. These types of pension plans are called defined-benefit plans.

With a defined-benefit plan, your employer sets aside money into an investment pool that is used to pay pension benefits to retired employees, usually based on some formula of number of years worked for the company, earnings and age.

For example, your employer may promise you a pension benefit that's equal to one percent of your average salary over the last five years times your total years of employment with the company. With this plan, your employer essentially guarantees that you'll receive a defined amount of money when you retire, regardless of how the investment pool performs. Unfortunately, many of us won't experience the benefit of a guaranteed pension at retirement as pensions are becoming few and far between.

Pension Plan vs. 401(k)

A defined-contribution plan is a more common retirement saving vehicle that most of us are familiar with through our place of employment. You'll recognize it as a 401(k) plan. With this type of retirement account, both you and/or your employer contribute money to your account. These types of funds are typically self-directed, meaning that you, the employee, are responsible for choosing how your contributions are invested, as well as how much you want to contribute from your paycheck through pretax deductions. If you're lucky, your employer may match a certain percentage of your contributions, allowing you to grow your retirement savings that much quicker. However, unlike a defined-benefit plan such as a pension, your employer isn't promising you a specific benefit amount when you retire, and what you end up with depends on how well your investment choices have performed. To learn more about 401k plans, visit our 401k Basics Guide.

Pension Plan vs. IRAs

An IRA, or individual retirement account, is a tax advantaged investment account used for retirement. The primary difference between an IRA and a pension plan is the source of money funding the account. Pensions are funded by employers, but individuals can contribute to an IRA regardless of where they work or whether they work.

With a traditional IRA, you may be able to deduct some or all of your contributions from your taxable income and may also be eligible for a tax credit equal to a percentage of that contribution. Amounts in a traditional IRA, including earnings, generally are not taxed until distributed. Amounts you withdraw from your IRA are fully or partially taxable in the year you withdraw them.

With a Roth IRA, you can avoid taxes when you withdraw money in retirement. Roth IRAs provide no tax break for contributions, but earnings and qualified withdrawals are generally tax-free.


Pension Plan vs Retirement Annuities

Like a pension, an annuity can convert to an income stream in retirement.. Unlike a pension, a typical annuity is purchased and funded independently, not by an employer. The growth in an annuity is tax deferred. That means your money can compound year after year, and you won't be taxed on your money until you take withdrawals. To ensure your future financial security, it's essential that you save for retirement. If you need help to better understand your investment options or to select retirement plan that best meets your objectives and goals, consult with a qualified financial advisor.


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