Which is better—a 401(k) or a pension plan?
A 401(k) and similar plans such as a 403(b) (which is for the non-profit sector including public schools, hospitals, churches) accumulate cash. After retirement, the employee takes responsibility for managing the account. A pension, however, allows retirees to receive guaranteed lifetime payments.
In the U.S., pensions are still common with public and government jobs, but have been largely replaced by 401(k)s in the private sector.2
The pros and cons of 401(k)s and pensions are explained in more detail below.
401(k) pros and cons
- One of the biggest upsides of a traditional 401(k) plan is that the contributions you make are tax-deferred. Roth individual retirement accounts (IRAs) are taxed up-front, but provide tax-free withdrawals. A portion of your salary goes directly into your 401(k) before taxes. It can then grow tax-free until you begin making withdrawals after you retire.
- The tax-deferred status brings three main benefits.
- First, you can lower your taxable income, which means you pay less in taxes.
- Second, you may be in a lower tax bracket in retirement than you were while you were working.
- Third, the account earnings grow on a tax-deferred basis. No taxes are due on earnings, which can generate more earnings, until you begin to take distributions.
- With a 401(k), you choose the portion of your paycheck to contribute and determine what fund or funds to invest in from the choices your plan offers. A big benefit is that some employers match your contributions up to a certain amount.
- When an employee retires, they assume the responsibility of managing the balance of the 401(k) account. The retiree therefore assumes all of the risk if the investments lose value. 2
Pension pros and cons
Fewer companies today offer traditional pensions. However, you can have a pension and still contribute to a 401(k) and an IRA. Having a variety of retirement vehicles can be a smart retirement strategy.
- With traditional pension benefits, you’ll keep receiving the same amount for the rest of your life. However, unlike Social Security payments, which factor in cost-of-living adjustments (COLA), most private-sector pensions offer fixed payments. Government pensions typically do offer COLAs, though they are capped and may not keep up during high inflation periods.
- Employees with traditional pensions have no say in the management of the funds. This can be both an advantage and a disadvantage. You don’t have to worry about choosing investments for your retirement or adjusting your asset allocation as you approach retirement. But investment decisions are made by the pension plan's managers, rather than by you.
- With a traditional pension plan, your pension is guaranteed, regardless of investment performance. But a pension fund could struggle if its investments don’t pan out or if there’s a recession. And it’s not unheard of for companies, and even municipalities, to go bankrupt and struggle to pay out benefits. There is a backstop: The Pension Benefit Guaranty Corporation (PBGC) is a government agency that guarantees your benefits up to certain maximums. But not every employer participates in the PBGC. Religious organizations can opt out, as can hospitals and schools associated with religious organizations.
- Before you’re guaranteed benefits, you must work for your employer long enough for your benefits to “vest.” Vesting can happen all at once, or it can occur in steps. Make sure you know your vesting schedule if you’re enrolled in a pension plan. It’s important to know if you’re walking away from a lot of money if you leave a job.
What can you do with my 401(k) after leaving your job?
You have several different options for what you can do with the funds in your 401(k) after leaving a job.
1. Leave the money in your former employer’s plan?
When you retire, you may have the option to keep your money in your former employer’s plan. If you are happy with the investment choices offered and the fees within the plan are reasonable, this can be a solid option.
Pros
- Your money continues to be administered by a team of financial professionals.
- Lower fees than most other options.
- Ongoing protection from creditors.
Cons
- You will be limited to the investment options offered by your former employer’s plan.
- You cannot continue to contribute to the plan when you retire.
- May require account minimums.
2. Roll over into an IRA
If you prefer more control over your investments, a traditional IRA might be the way to go. That’s because you can select the management style, expense ratio, and investment options that best suit your needs.
Pros
- If you have earned income, you can continue contributing past age 70½.
- You will have a wider range of investment options than most 401(k) plans.
- You can combine your IRA with other retirement assets for easier management.
Cons
- Fees may be higher than employer-sponsored plans.
- You cannot borrow from a traditional IRA.
- Limited protection from creditors.
3. Convert the funds to a Roth IRA
Much like a traditional IRA, Roth IRAs offer greater control over your assets than is usually the case with a 401(k). In this case, you pay ordinary income taxes on any money you roll over, but future earnings will be tax-free (provided the account is at least five years old and you are at least age 59½).
Pros
- Qualified withdrawals are 100% tax-free.
- No mandatory withdrawals once you reach age 73.
- Additional contributions are allowed if you do not exceed income limits.
Cons
- You cannot borrow from a Roth IRA.
- Possibly higher fees compared to employer-sponsored plans.
- Must pay taxes in the years of the rollover.
4. Use the money to purchase a lifetime annuity*
If you are looking for a long-term, low-risk retirement solution, you may want roll your assets into a guaranteed lifetime income annuity. With this type of annuity, you don’t have to worry about outliving your money or how the market performs because you will receive guaranteed income checks for the rest of your life.
Pros
- Guaranteed income for life.
- You can use your annuity payments to satisfy your required minimum distributions (RMDs).
- Payments are unaffected by market downturns.
Cons
- Often come with high fees and commissions.
- You will have less liquidity than with other investment options.
- Annuities can be complicated, so it’s important to work with a financial professional.
5. Take a lump-sum distribution
While you have the option to liquidate your 401(k) and take the money you’ve saved in a lump sum, it’s important to know that the IRS does not consider this a “rollover.” Since your assets are not being transferred into another tax-deferred account, it’s important to weigh the pros and cons carefully.
Pros
- You have immediate access to your money.
Cons
- Possible 10% penalty for withdrawals prior to age 59½.
- Loss of tax-deferred status on any future earnings.
- 20% automatically withheld for income taxes.
- Additional federal, state, and local taxes may be due.
