People who are serious about preparing for their retirement years often consider various types of retirement plans, including a 401(k) and a pension plan of some type. In fact, both of these approaches provide significant benefits when it comes to creating a solid financial foundation for later life. There are significant differences between a 401(k) and a pension plan that many overlook, since both are seen as a way to save for retirement.
With a 401(k) plan, an employer withholds a portion of the employee’s income as a contribution to the plan. This contribution is not taxed, a benefit that allows the employee to claim a deduction at the end of the tax year. In some cases, the employer may match the contribution made by the employee, up to a certain amount per calendar year. Those contributions earn interest, but all taxes are deferred during this period. Should the employee choose to exit the plan for any reason and receive the balance of the plan in cash, then federal and state taxes are immediately assessed. In many nations, withdrawal of the funds prior to a certain age will result in an additional penalty.
Pension plans typically do not include funding by the employee. Instead, an employer makes regular contributions on behalf of the employee, with the figure usually related to the pay rate of that employee. Since the employee is not contributing part of his or her income to the pension plan, there is no opportunity to claim a tax deduction for every year that the employee is enrolled in the plan. This means that taxes must be paid on any disbursements made from the plan, which may be a lump sum payment or a series of monthly payments, depending on the structure of the pension.
Another key difference between a 401(k) and a pension is that the 401(k) does not provide the opportunity for monthly disbursements. At the time of retirement, the balance of the 401(k) can be taken as a lump sum, which requires paying taxes on the entire amount at one time. An alternative is to roll the balance of the 401(k) into a government approved retirement plan that does allow monthly disbursements, a strategy that results in only paying a portion of taxes each year.
In addition, these types of plans earn returns in a different manner. Employees in a 401(k) control how much they contribute each pay period, as well as having some say in which investments he or she participates in, within the scope of the plan. This means that the amount saved for retirement is based on both the amount of the contributions and the performance of the investments chosen by the employee. By contrast, the pension plan is based on the amount contributed annually by the employer, and normally provides a fixed amount that can be calculated in advance with relative ease.
Many investors choose to participate in both a 401(k) and a pension plan. In some countries, it is possible to be involved in a 401(k) provided by a union or professional association, while also participating in an employer provided pension plan. This approach allows individuals to generate two streams of retirement income simultaneously, effectively making it possible to reap the benefits of each approach, while minimizing the potential impact of any drawbacks.