What is a pension? What is a 401k?
One of the best benefits that a job can offer is an employer contribution to a retirement savings account. What does that mean in practical terms? In addition to paying you to do your job, your employer will also help you put away money for retirement. There are two main types of “employer sponsored retirement plans” that you should know about: a defined benefit plan (e.g., pension) and a defined contribution plan (e.g., 401k).
What are defined benefit plans?
A defined benefit plan is one where the employer provides a specific benefit in retirement. That is, your employer commits to paying you a certain amount of money in the future. The most popular form of defined benefit plan is a pension.
Pensions are retirement plans offered by an employer that pay you a certain amount of money every year after you retire. You have money taken out of each paycheck so you partially fund it yourself, and your employer continues to pay you a certain amount once you retire.
Pension plans have become less and less common over time due to the high ongoing costs to companies that offer them. Someone can work at a company for a certain period of time and then that company owes them a paycheck for the rest of their life. As a result, private companies infrequently offer pension plans today. Employers that still offer pension plans are usually government entities. State and federal employees, including teachers and military service members, are often eligible for pensions after a certain period of service (e.g., 20 years or more).
As an alternative, many employers have begun to offer defined contribution retirement plans, such as a 401k.
What is a defined contribution plan?
A defined contribution plan is one where the employer provides a specific contribution to a savings account at that time. In contrast to a defined benefit plan where the employee gets a certain amount of money in retirement, a defined contribution plan puts money in a retirement plan for the employee and lets the employee make decisions with it until retirement.
A 401k plan is a popular defined contribution retirement plan offered by employers. An employee can enroll in a 401k and contribute money on a pre-tax basis (i.e. they contribute money before it has been taxed, so they lower the amount of taxes they have to pay) to a retirement savings account. The employer may offer a “match”, which means they will add additional money to the employee’s account if the employee makes a contribution.
When the employee reaches age 59 ½, they can start to withdraw money from their 401k without any penalties. Early withdrawals are allowed with certain penalties. Upon withdrawal, the money from a 401k will be taxed as regular income.
Money in a 401k can be invested and usually is managed by a professional investment firm. Depending on the plan, employees will just choose their investment preferences and a professional or algorithm will decide what to invest in for them. 401k plans are subject to IRS restrictions, so an employee and employer can only contribute up to a certain threshold ($20,500 employee contribution for 2022).
The money in a 401k belongs to the employee, not the employer. If an employee leaves their employer, the money in their 401k still belongs to the employee. They can leave that money in the same account, add that money to a new 401k offered by their next employer, or add that money to a Traditional IRA (an individual retirement account).
