“Understand the differences between each plan to decide which retirement income stream is best for you.”
No matter your type of work, when it’s time to retire, you’ll want to have as many income streams as possible, says U.S. News & World Report in the article that compares two sources “Pension vs. 401(k).” Start with the understanding that Social Security was designed to provide only about 40% of the average worker’s income. Where does that other 60% come from?
A traditional pension plan, or a defined contribution plan, like a 401(k) account, are two of many retirement savings options. Both plans are designed to provide retirement income, but they are very different in how they are set up and administered.
Most people think a pension is better, but fewer people today have that option. There are also several reasons why a 401(k) is a better way to go, as long as the owner is financially educated and has the discipline to set aside short-term spending for long-term retirement goals.
Let ‘s look at the differences.
Pensions give workers a monthly payment in retirement, if they meet certain eligibility standards. Someone usually has to work a certain number of years to receive a pension and must reach a specific age, before they can start getting payments. The formula is usually calculated based on earnings and years of service.
Employers fund pensions and there’s no employee contribution needed. There’s a tradeoff though: workers have little or no control of how they receive their pension. Most have to be taken in monthly payments, while some companies do allow a lump sum payout.
The usual option is to take a monthly payment to permit a surviving spouse to continue to receive the pension payouts. The monthly payout may be less than a lump sum, but the surviving spouse enjoys the benefit of continuing income after the worker dies. This is often a decision that can be made only one time.
Fewer and fewer companies offer pensions today. Twenty years ago, nearly 60% of large companies offered pension plans. In 2017, only 16% of companies offered pensions to new hires. Pensions are expensive. This is underscored by government pensions, also known as public pensions, which are now scrambling for funding. Moody’s Investor Services calculated that public pensions in 2018 were underfunded by $4.4 trillion. For teachers and civil servants, that’s a worry. In the private sector, the Pension Benefit Guaranty Corporation (a government agency) insures the pensions of 37 million private employees.
401(k) plans replaced pensions for most workers. This puts the onus on the worker to have money taken out of their paycheck (pre-tax). In 2019, employees can contribute as much as $19,000 to a 401(k) plan. Workers 50 and over can add $6,000 in catch-up payments, for a total contribution of $25,000.
Some employers make contributions to their worker’s retirement accounts. However, many workers need to be employed for a certain amount of time, before they are entitled to the funds. Some companies will match an employee’s contribution, if they meet certain contribution levels.
There are two types of 401(k) plans. Traditional 401(k) plans offer a tax deduction at the time that contributions are made. Money grows in the account tax-free, but when withdrawals are made, after retirement, they are subject to income taxes. If you take money out before age 59½, there might be a 10% penalty. Once you reach age 70½, you must take a certain amount out every year, called a Required Minimum Distribution or RMD.
The Roth 401(k) plan does not provide a tax deduction for contributions, but money can be withdrawn tax free during retirement. Depending on the account, there may be a 10% penalty for an early withdrawal, but that only applies to investment gains. Since the contributions have already been taxed, there’s no penalty for withdrawing a portion of the principal early. Unlike the traditional 401(k), there are no RMDs.
Which is best? Few of us have that choice today, but there’s a lot to like about pension plans. If investments don’t perform in a 401(k), there’s no guarantee of having enough money to retire on. However, a 401(k) is not subject to a company deciding to cut pension payments, and lets you decide where your money is invested. There are pros and cons for both kinds of retirement savings plans.
Reference: U.S. News & World Report (Dec. 21, 2018) “Pension vs. 401(k)”