Nowadays, many employers offer employees access to retirement plans. These plans are an important component when it comes to employees planning for their financial futures. The two main types of retirement plans include defined benefit plans and defined contribution plans, with the latter being more popular in recent years. Pensions are the primary defined benefit plan available to employees, while 401(k)s are the primary defined contribution plan available to employees. It will almost never be the case that an employee has to choose between a pension plan and a 401(k) plan, but it is important to understand the distinct differences, should you run into these at different points in your professional career.
THE PURPOSE OF RETIREMENT PLANS
Before anything else, let us start by answering one of the most basic questions of all: what is the purpose of a retirement plan? Well, as you can probably tell from the name, these plans are critical components of planning for your retirement. There will come a point when you stop working, so you must have enough funds set aside to cover your expected future costs during that time.
Pension plans are defined benefit retirement plans that were much more popular in the past. Now, pension plans are becoming increasingly replaced by 401(k) and are now found mostly in government-related jobs. With a pension plan, the burden falls mostly on the employer, who allocates money and invests it on the employee’s behalf. The employer decides where the money gets invested and, in theory, guarantees consistent annual payouts to employees once they retire.
The fact that the employee has no control over where the funds get invested can be both a positive and a negative. While they do not need to worry about the effort of investing, they do have to deal with the risk that those funds get put into poor investments and the small but meaningful chance that the employer goes bankrupt and cannot pay out its pension obligations. Of important note, pension plans often involve a vesting feature whereby you must work for an employer for a certain number of years before being eligible for pension, so be sure to check the details of this with your employer.
401(k) plans are defined contribution retirement plans that are becoming increasingly popular at present. With a 401(k) plan, the burden falls on the employee, who determines how much of each paycheck they want withheld for their retirement account. The employee decides where their money gets invested and does not have any guarantee from the employer about payouts. Employees manage their own retirement accounts and can typically choose from several different funds to invest in through their employer.
With a traditional 401(k), employees benefit immensely from the fact that their retirement account contributions consist of pre-tax dollars. This is a huge potential benefit when it comes to taxes because you not only decrease your taxable income at present but given that you are only taxed when you withdraw from your 401(k) in retirement, you can also save if you retire at a lower tax bracket than you are in at present. Many employers will match employee contributions up to a certain percentage in order to encourage them to save. Of important note, there is typically an annual limit on pre-tax dollars you can contribute to your 401(k), so if you can, you should try to contribute up to the limit in order to maximize your tax benefit.