Building a financial foundation for your retirement might sound like hard work, but it doesn't have to be. Pensions and 401(k) plans can help ensure you'll have enough money to retire on, so all you'll have to worry about is which island to choose.
Pensions and 401(k)s are the most common retirement plans that are employer-sponsored. That is, you sign up for them at work. Understanding the two types of plans is a good first step on the path toward your retirement goals.
While you can invest for retirement on your own using a traditional IRA or a Roth IRA, your employer will likely offer a pension or a 401(k) plan — and you won't want to miss out on either.
Here’s how they work, and how they differ.
What is a pension?
A pension plan is a defined benefit plan, meaning you get a specified payment amount — in the form of monthly checks or a lump sum — during your retirement years. Pensions are funded by your employer; the company puts aside money and invests it on your behalf.
How much pension income can you count on in retirement? There’s a formula for that, and it's based on:
- Your annual salary.
- The number of years you’ve worked for the company.
- Your age at retirement.
You're not eligible to receive any money until you've been vested. That's not about having the right fashion accessory — it means you need to work for the company for a certain number of years before you qualify for your pension.
What is a 401(k)?
A 401(k) is a defined contribution plan, meaning your benefits in retirement are determined by how much money you and your employer contribute to the plan.
Yes, your employer, too: Your company might match a portion of the money you put in, up to a certain percentage of your income.
Let’s say you want to contribute 10% to your plan. If you earn $2,000 each payday, $200 will be taken out of your pay and placed into your 401(k). Your employer might contribute 50 cents for every dollar you put in, up to 6% of your salary.
One benefit of a 401(k) is that it’s tax-deferred. A part of your paycheck goes directly into your plan before income taxes are taken out, and the money grows tax-free until you withdraw it in retirement.
But if you make a withdrawal too early — before age 59 1/2 — you'll owe taxes, plus a stiff 10% penalty.
The main downside to a 401(k) plan is the risk that you'll run out of funds during your retirement if you failed to contribute enough while you were working. Smart budgeting throughout your life is the best method for avoiding this nightmare scenario.
Pension vs. 401(k)
The main differences between these plans involve how the money is contributed, and how it's dispersed after you retire:
- Pensions have traditionally been funded completely by employers. A 401(k) is largely funded with employee savings, though the company may sweeten the pot.
- A pension offers guaranteed payments in retirement until you die, or until the company goes belly-up. A retiree with a 401(k) may make penalty-free withdrawals of any size after age 59 1/2 — and must watch the balance carefully, to avoid running out of money.
- You can access your pension in retirement once you've worked for the employer for a certain number of years — even if you quit the job long before retirement. If you leave you a job where you have a 401(k), you can keep the account right where it is or roll it over into an IRA.
Which should you choose: a pension or a 401(k)?
That's a trick question, because most likely you won’t decide whether you get a pension or 401(k). That’s usually determined solely by the employer — and many of them have decided pensions are too expensive.
Today, 401(k) plans are far more prevalent. Only 22% of all U.S. workers currently have pensions, including just 13% of those working in private industry, according to the most recent data from the U.S. Bureau of Labor Statistics.
If a pension sounds appealing to you, your best bet for landing one is to take a job in the public sector, such as in government, education or public safety.
And If you happen to work for a company that doesn’t offer a pension or a 401(k), be sure to save and invest on your own. The best tip is to start saving early and often.
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