By Jon Powell, CFP®
With many kinds of retirement plans out there, it can be hard to tell the differences among them at first glance. Two of the most popular types of retirement plans offered by employers are the 401(k) plan and the pension plan.
An employer typically provides one or the other, but not both. While it’s unlikely that you’ll have a choice between the two, you’ll probably come across one of these plans throughout your working years, so it’s essential to understand how they work and what they mean for your retirement.
A 401(k), or defined-contribution plan, is a common retirement plan offered by employers. With a 401(k), you elect to contribute part of your salary into a retirement account. You can choose from a range of investments such as index funds, mutual funds, and target-date funds.
You also have the ability to change your investments, however, they are limited to the investments your employer offers. You can contribute up to $20,500 (as of 2022) each year, and if you are 50 years of age or older, an additional $6,500 catch-up contribution.(1)
Your employer may also choose to match your contributions up to a certain amount. The total limit for employee and employer contributions is $61,000.
There are two types of 401(k) plans: a traditional 401(k) and a Roth 401(k). In a traditional 401(k), your contribution is taken from your salary pre-tax. Your traditional 401(k) grows tax-deferred, and you only pay taxes when you withdraw from the account in retirement.
Because these contributions are tax-deferred, contributing to a traditional 401(k) means you lower your taxable income at the time you contribute.
A Roth 401(k) is funded with money after you’ve already paid taxes on it. The money in your Roth 401(k) grows tax-free in your account, and since you’ve already paid taxes on your contributions, when you withdraw funds, you withdraw them tax-free.
Thus, the key difference between the two boils down to when you pay taxes. If your employer offers both, you need to decide whether it makes sense for you to pay taxes now or when you retire.
A pension plan, or a defined-benefit plan, is an employer-sponsored plan that guarantees an amount of income in retirement. The amount you receive in retirement is determined by a few factors, such as your length of employment, your salary, your age at retirement, and any other specifications set by the employer.
Your employer is responsible for contributing to the plan and all the investment risk is on them as well. However, you may need to work several years at the organization before you are eligible for a pension plan. Additionally, with a pension plan you have no control over how it’s invested.
Depending on the plan, you may be allowed to contribute part of your salary as well. You are also guaranteed regular payments for the rest of your life, though the plan might offer you the choice of a lump-sum payment.
Both plans have their advantages and disadvantages. Pension plans have been around longer, however, 401(k) plans are much more common today. In fact, as of March 2021, 52% of employees had access to a defined-contribution plan such as a 401(k), while only 3% had access to only a pension plan (12% had access to both).(3)
If you have a 401(k), it is up to you to save for your retirement. You have more control but more responsibility as well. With a pension plan, your employer is responsible for funding the plan.
If you like knowing you will have a guaranteed income in retirement and prefer not having to contribute any of your own money, a pension plan will be more attractive to you. If you’d rather have more control over how much you put toward retirement, a 401(k) may be a better fit for you.
Planning for retirement can feel daunting—but you don’t have to figure it out all by yourself. Choosing the right partner as you plan for the future can help you set yourself up for success in retirement. And finding a financial advisor that understands your unique situation and goals doesn’t have to be difficult.
At Ferguson Johnson Wealth Management, our mission is to simplify navigating the complexities of retirement, helping you plan wisely so you can live fully.
We understand that retirement plans are not one size fits all. That’s why we work with you to develop a plan tailored to your needs. Reach out to us at 301-670-0994 or by email.