Whether it’s a pension or a 401(k) plan, the type of retirement policy you have will often determine when you can retire. Learn more about a 401(k) and a traditional pension plan.
What is the difference between a 401(k) and a pension?
A 401(k) is an employer-sponsored retirement account that allows an employee to divert a percentage of his or her salary—either pre- or post-tax—to the account. A traditional pension plan offers retirees a fixed monthly benefit for the rest of their lives. How do they work?
401(k) plans
- For a 401(k), an employee chooses a percentage to be automatically taken out of each paycheck and invested in a 401(k) account. The employee then picks which investment options offered in the plan to allocate these funds to.
- Depending on the details of the plan, matching contributions may be made by the employer. The money invested will generally be tax-deferred, meaning you will not owe taxes on it until it is removed from the plan. If your employer matches contributions, financial experts recommend that you contribute enough each year to get the maximum match.
Pension plans
- A pension plan is a retirement plan that requires an employer to make contributions to a pool of funds set aside for a worker's future benefit. The pool of funds is invested on the employee's behalf, and the earnings on the investments generate income for the worker upon retirement.1
- Pensions are usually paid out in guaranteed regular payments until the employee dies. However, payments may be passed on to a surviving spouse or child depending on the plan. Your pension amount is determined by a few different factors, including your salary, the number of years you worked for your employer, and any special terms your employer may have set.
Which is better—a 401(k) or a pension plan?
A notable difference between these two retirement plans is that 401(k) plans are defined contribution plans since the employee is primarily responsible for funding, while traditional pensions are defined benefit plans as the employer funds the program
401(k) plans
- One of the biggest upsides of a 401(k) plan is that the contributions you make are tax-deferred. A portion of your salary drops directly into your 401(k) before taxes. It can then grow tax-free until you begin making withdrawals after you retire.
- The tax-deferred status brings two main benefits. First, you can lower your taxable income, which means you pay less in taxes. Second, you may be in a lower tax bracket in retirement than you are while you are working.
- With a 401(k), you choose the portion of your paycheck to contribute and determine what fund or funds to invest in from the choices your plan offers. A big benefit is that some employers match your contributions up to a certain amount.
Pension plans
- With traditional pension benefits, you'll keep receiving the same amount for the rest of your life. Employees with traditional pensions, however, have no say in the management of the funds. This can be both a benefit and a disadvantage. On the one hand, you don’t have to worry about choosing investments for your retirement or adjusting your asset allocation as you approach retirement. On the other hand, your nest egg is in the hands of a fund manager who may make mistakes.
- With a traditional pension plan, your pension is guaranteed, regardless of investment performance. But a pension fund could struggle if its investments don’t pan out or if there’s a recession. And it’s not unheard of for companies, and even municipalities, to go bankrupt and struggle to pay out benefits.
- Before you’re guaranteed benefits, you must work for your employer long enough for your benefits to “vest.” Vesting can happen all at once or it can occur in steps. Make sure you know your vesting schedule if you’re enrolled in a pension plan. It’s important to know if you’re walking away from a lot of money if you leave a job too early.
What do I do with my 401(k) after retirement?
You can either leave the money from your 401(k) in your former employer’s plan or you can roll over that money into an Individual Retirement Account (IRA) or an annuity. Rolling over your 401(k) will give you more control over how your money is invested. This is also a good time to begin consolidating the various retirement assets you may have accumulated, making your retirement planning more manageable and easier to track.
What are 401(k) rollover options?
Most people choose to roll over or transfer their funds to an IRA or to the 401(k) plan of a new employer. A Roth IRA is another type of individual retirement account. The difference is that with a traditional IRA the money you put in isn't taxed, but withdrawals are. With a Roth IRA, the money you put in is taxed, but when you take it out the money you’ve invested isn't taxed. If you have not reached age 59½, though, you may owe taxes and a 10 percent penalty on earnings. A much less popular option is to cash out your 401(k), but this comes with significant penalties; income taxes must be paid, and if you’re under age 59½ there will be an additional 10% penalty tax. When considering rolling over the proceeds of your retirement plan to another tax-qualified option, such as an IRA, please note that you may have the option of leaving the funds in your existing plan or transferring them into a new employer’s plan. You may wish to consult with your new employer, if any, to learn more about the options available to you under your plan and any applicable fees and expenses. You may owe taxes if you withdraw funds from the plan. Please consult a tax advisor before withdrawing funds.
Are there other retirement income options besides a 401(k)?
One example has already been discussed here: traditional pensions, which offer a fixed monthly benefit for the rest of your life. Another option is a Guaranteed Lifetime Income Annuity. This type of annuity, will provide a steady stream of income that's guaranteed to last for the rest of your life—no matter how long you live.1If you purchase an annuity, you won’t have to worry about the impact that a decline in the market would have on your payments.
What’s the safest 401(k) option?
Many 401(k) plans offer a stable value option. This pays a guaranteed rate of return for the year. The rate will change from year to year, but it is relatively stable. While it is safe in terms of preserving your money, it does not provide the upside potential that riskier options may provide.
Why do people with 401(k)s retire later?
While there are many potential reasons for those with 401(k) plans to retire later, most of them can be boiled down to a single word: uncertainty. While traditional pensions promise retirees a fixed monthly benefit for the rest of their lives, 401(k)s and other defined contribution plans offer no such guarantees.
Since the money we set aside in a 401(k) may have to last well into our 80s or 90s, it comes as no surprise that workers with these plans are delaying retirement in order to build the largest possible nest egg.2
How much do you need for retirement?
With a 401(k), the burden of saving for retirement shifts from the employer to the employee. But how much money do we need? While financial experts routinely toss around figures that range between $1 million and $2 million, the amount we need to save depends greatly on the lifestyle we hope to lead.
New York Life is here to help you learn more about Guaranteed Lifetime Income Annuities or other retirement options.
This article is for informational purposes only. Neither New York Life nor its agents provide tax, legal, or accounting advice. Please consult your tax, legal, or accounting professional before taking any action.
1Guarantees are subject to the claims-paying ability of the issuer.
2“Boomers Find Reasons to Retire Later,” Research at Boston College. November 29, 2018. https://squaredawayblog.bc.edu/squared-away/boomers-find-reasons-to-retire-later/
Investments are offered through NYLIFE Securities LLC (memberFINRA/SIPC),a Licensed Insurance Agency and a New York Life company.
