401k vs. Pension – The Key Differences Explained

Tuesday, June 21, 2022 12:08 Posted by Admin

You work hard and make enough money to support your current lifestyle. But the future is going to arrive faster than you think, which means retirement is always looming on the horizon. While you’re looking forward to spending your golden years away from work, you also want to ensure that you’re financially stable.

You know this. Your employees know this. And that’s why you need to offer appropriate retirement plans.

And when it comes to finances, one of the big questions your employees face is whether they should go with a 401k or a pension plan. Is a 401k or a pension plan better? Can they have both? This article shows you the differences between the two retirement plans so you can make the right choice for your employees and your business.

What Is a Pension Plan?

Pension plans are retirement accounts that are both funded and sponsored by your employer. They can have several different names, including a “defined benefit plan.” Generally speaking, these plans are provided as employment plans in addition to the state pension provided by the Department of Labor. Retirement plans often hinge on the quality of these pensions and the funds they’ll provide when you’re no longer working.

Most pension plans use a formula that takes several factors into account:

• The employee’s age
• Salary
• The number of years they’ve worked for your company

As an example, a pension plan may equate to 2% of an employee’s average salary for the last five years of their employment. Then, you may multiply that number by the number of years the person worked for you. As such, an employee may get a stronger pension plan if they work with the same employer for the majority of their career.

These plans require employers to commit to making regular payments on behalf of the employee. As such, you get to control the plan.

What Is a 401k?

People often confuse 401ks with pension plans because some employers refer to them as a 401k pension. That’s not strictly accurate. While a 401k can help people prepare for retirement, it works differently from a traditional pension plan.

A 401k is a retirement plan that offers several tax advantages. If an employee signs up for one, they agree to contribute a percentage of their salary into an investment account. As an employer, you may fully or partially match these contributions as a bonus to starting a plan. The contributed money is then invested, with the employee having the choice between several investment options. Most go for mutual funds, though many 401k plans offer different investing vehicles.

The key benefit of these plans is that no taxes are levied on the employee’s contributions until they withdraw them. They also allow people to withdraw from them early. As such, 401ks are often considered one of the most tax-efficient ways to save for retirement. The downsides are that employees are often required to meet a minimum contribution number and that they will pay a heavy 10% additional tax if they withdraw early. This occurs if someone withdraws before they are 59-and-a-half or if they don’t meet the IRS’s criteria for early withdrawal.

Pension Fund vs. 401k – The Key Differences

Now you know the basics, the big question is which should you choose? There are several major differences between 401ks and pension plans that will inform your choice.

Difference No. 1 – Your Contributions

Employees are expected to make contributions out of their own salaries with a 401k. Pension plan contributions come directly from the employer, meaning employees don’t lose out on any of their salaries while still getting to put money away in a retirement fund.

While this may make it seem that pension plans are the better option for employees, that’s not always the case. As mentioned, 401k contributions are not taxed until they’re withdrawn. Assuming the employee withdraws when they reach the appropriate age or meet the IRS’s conditions, they’ll pay a lower tax rate on the money than they would if they withdraw funds early. Furthermore, an employer may have a contribution matching scheme, which means the employee still benefits from employer contributions with a 401k.

Pension plans are much simpler because you make contributions on behalf of your employees. However, they offer less flexibility in terms of how much money an employee can put into their retirement pot.

Difference No. 2 – The Investing Issue

With a pension plan, employees are guaranteed a set income for life. They sign an agreement with you and you then contribute to their pension pot. The employee receives the money in pre-agreed increments when they retire. If the investment market drops, employees don’t have to worry about their retirement income getting affected. They still receive the sums you agreed to when they signed up for the pension plan.

A 401k differs because the money people contribute gets invested. While the employee chooses where it’s invested, the fact that it’s invested at all creates risk. If they make the wrong choices, their 401k can get depleted, leaving them with less money than they contributed. The upside to this is that the right investments generate strong returns that leave employees in a stronger financial position when they retire. Still, many people don’t have in-depth knowledge of investing, meaning they may need to consult a financial advisor when deciding what to do with their 401k.

Difference No. 3 – Control

Building from the previous point, control is another key issue in the battle of 401k vs. pension. With a pension plan, the employer controls how much money goes into the retirement pot. Employees may feel like this places them at a disadvantage, especially if you don’t offer a strong pension plan.

By contrast, employees maintain full control over their 401k at all times. That means they get to choose where their contributions are invested, in addition to being able to withdraw money from the plan at any time. Of course, this control comes with the previously discussed risks. Plus, there are tax penalties for exercising the ability to withdraw from a 401k early. Still, a 401k may be a better option if employees need access to their savings in emergencies. They also remove the burden of control from the employer’s shoulders.

Difference No. 4 – Portability

Pension plans are non-portable. They’re tied to the employer, which means employees can’t transfer them. If we assume you are an employee for a moment, let’s say you work for Company A for 10 years before deciding to take a new opportunity with Company B. The pension plan you had with Company A stays with that employer. As a result, you have to start a new plan with Company B. Thankfully, this doesn’t mean you lose the pension benefits from Company A. However, you’ll need to keep track of the Company A pension and apply to release it when you’re ready to receive your payments.

While employees set up a new 401k if they change jobs, the original one isn’t tied to the original employer. People can roll the old plan into their new one, creating a less complicated system. Furthermore, they can roll a 401k into several other types of retirement plans, such as an individual retirement account (IRA).

Difference No. 5 – Maturity Time

One of the key benefits of a 401k is that it can start generating returns on investments immediately. Assuming the employee makes the right choices, their contributions can start growing from the moment they’re made.

Pension plans also allow an employer’s contributions to generate more money. However, it takes much longer for a pension plan to start showing returns. Typically, employees have to wait between five and seven years before the fund becomes vested, which means it’s ready to provide financial benefits.

Difference No. 6 – Tax Benefits

With a traditional pension plan, employees pay income tax at the regular rate each time they receive one of their periodic pension payments. If someone chooses to take all of the money out in a lump sum, they must pay the entire amount of tax they owe in the same year.

As deferred retirement savings schemes, 401ks work differently. Employees don’t pay a penny of tax on their contributions while they’re making them. This means the contributions come out of their pre-tax income. This offers both immediate and future tax benefits that your employees may be interested in.

For the immediate benefits, the employee may choose to contribute a large enough sum of money to reduce their taxable earnings to the point where they move into a lower tax bracket. This could be a concern for the employer if they offer a full contribution matching scheme.

In terms of future benefits, people pay no tax on the money their contributions generate for as long as that money stays in their 401k. They only pay tax, at their regular rate, when they start withdrawing funds.

Can You Have a Pension and 401k?

As you can see, pensions and 401ks each have pros and cons. While pensions are more stable, 401ks allow employees to control contributions and potentially make more money for their retirement. The decision between the two is often difficult, which may lead to you asking a question:

Can you have a pension and 401k?

The good news is that you can. Nothing is stopping you from setting up a pension plan and a 401k, meaning employees can benefit from the best of both worlds. You could provide your people with the ability to rely on their pension to provide a stable income. This allows them to take more risks with their 401k so they can potentially generate higher returns on the contributions made into it.

The challenge you’ll face is two-fold.

First, many employers don’t offer the option of both a traditional pension plan and a 401k. Because 401ks place the responsibility for retirement planning on the employee, many employers choose to offer them alone. That’s especially the case if the employer operates a contribution matching policy. By offering both, your business assumes responsibility for a pension plan while potentially making contributions to a 401k. That’s more money spent, which can affect your company’s bottom line.

Second, having both means employees have a more complex retirement fund. They need to control their 401k while keeping track of what’s happening with their pension plan. This complexity increases if the employee changes jobs, meaning they have multiple pension plans to track. What’s more, employers have to maintain pension plans on behalf of employees who’ve left their companies.

What’s the Government’s Role in Retirement Savings?

In addition to the numerous types of pension plans available, people can also receive social security when they retire. Social security provides retirees with stable sources of income, in addition to benefits that can support dependents in the case of the retiree’s death.

Because Social Security is a federal program, many make the mistake of thinking it’s operated by the Department of Labor. Pension plans are certainly overseen by this department. However, it is not responsible for Social Security, which is a separate program from those operated by the Department of Labor. Retirement planning involves you understanding the differences between Social Security and your independent retirement plans.

The Department of Labor’s main pension-related responsibilities revolve around the enforcement of the Employee Retirement Income Security Act (ERISA). This act exists to ensure that employees and employers receive the pension plan information they need to make appropriate choices. It also provides compliance assistance for employers to ensure they’re offering various pension plans properly. The Department of Labor created the Employee Benefits Security Administration to keep track of ERISA issues and provide general oversight. It also set up the Pension Benefit Guaranty Corporation, which is a pension plan information resource that exists to answer any questions you may have.

Is a 401k or a Pension Plan Better?

As both types of retirement plans offer pros and cons for your employees, you need to make your choice based on the benefits you wish to offer and your desire for control over employee retirement planning.

Traditional pension plans offer stability, meaning employees are guaranteed to receive the money the plan lays out when they retire. If someone intends to stay with the same employer for their entire career, these plans are also simpler than 401k. They don’t have to manage the plan, meaning the burden for overseeing a pension plan lies on the employer. The downside here is that your business makes all of the contributions.

That’s not the case with 401ks because the employee has more control over the plan. They commit to making contributions, which your business can choose to match. These plans are also riskier for employees because of this control. If one of their investing decisions goes wrong, they lose out. However, 401ks offer more flexibility and portability, in addition to several tax benefits. Your company could use these facts to use 401ks as a way to attract better talent.

Even with all of this information, you may still feel confused about which option wins in the battle between 401k vs. pension. That’s where Taylor Benefits Insurance comes in. We work with employers to help them create attractive employee benefits plans. If you have any questions about how retirement plans fit into these packages, we’re here to provide advice for your business. Get in touch with us today and we’ll help you create a powerful employee benefits package.