Retiring with a 401(k) plan or a traditional pension plan?

What is the difference between a 401(k) and a pension?

A 401(k) is an employer-sponsored retirement account that allows an employee to divert a percentage of his or her salary—either pre- or post-tax—to the account. A traditional pension plan offers retirees a fixed monthly benefit for the rest of their lives. How do they work? 

401(k) plans

• For a 401(k), an employee chooses a percentage to be automatically taken out of each paycheck and invested in a 401(k) account. The employee then picks which investment options offered in the plan to allocate these funds to. 
• Depending on the details of the plan, the employer may make matching contributions. The money invested will generally be tax-deferred, meaning you will not owe taxes on it until it is removed from the plan. If your employer matches contributions, financial experts recommend that you contribute enough each year to get the maximum match.
  

Traditional pension plans

• A traditional pension plan is a retirement plan that requires an employer to make contributions to a pool of funds set aside for a worker's future benefit. The pool of funds is invested on the employee's behalf, and the earnings on the investments generate income for the worker upon retirement.¹
• Pensions are usually paid out in guaranteed regular payments until the employee dies. Depending on the plan, however, payments might be passed on to a surviving spouse or even a child. Your pension amount is determined by several factors, including your salary, the number of years you worked for your employer, and any specific terms your employer may have set.

Which is better—a 401(k) or a pension plan?

• Traditional pensions are defined benefit plans. The amount of the pension is specified. The employer funds the plan and bears the investment risks.
• 401(k) plans are defined contribution plans. The employee funds the plan (often helped by a match from the employer) and bears the investment risks.
• If investments in the 401(k) do well, the employee may end up with more than the employee would get with a traditional pension. But if the investments do not do well, the employee could end up with less.

401(k) Benefits

• One of the biggest upsides of a 401(k) plan is that the contributions you make are tax deferred. A portion of your salary drops 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 grows tax free. No taxes are due on earnings, which 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.

Pension pros and cons

• With traditional pension benefits, you'll keep receiving the same amount for the rest of your life.
• 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 your nest egg is in the hands of a fund manager who may make mistakes.
• 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), a government agency, 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 I do with my 401(k) after retirement? 

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 solid option.

Pros 

• Your money continues to be administered by a team of 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. Rollover into an individual retirement account (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 them 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 59 ½).

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 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.

4. 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 59 ½.
• Loss of tax-deferred status on any future earnings.
• 20% automatically withheld for income taxes.
• Additional federal, state, and local taxes may be due.

Frequently asked questions

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New York Life is here to help you learn more about Guaranteed Lifetime Income Annuities or other retirement options.

This article is for informational purposes only. Neither New York Life nor its agents provide tax, legal, or accounting advice. Please consult your tax, legal, or accounting professional before taking any action. 

¹Guarantees are subject to the claims-paying ability of the issuer.  

²Nathan Place, “5 Reasons Americans Are Retiring Later in Life,” Financial Planning, August 8, 2022. https://www.financial-planning.com/list/5-reasons-americans-are-retiring-later-in-life

Investments are offered through NYLIFE Securities LLC (member FINRA/SIPC), a Licensed Insurance Agency and a New York Life company.

*Annuities or tax deferred investments in tax qualified retirement plans (like IRAs, TSAs, and SEPs) already provide tax deferral under the Internal Revenue Code, so the tax deferral of an annuity does not provide any additional benefits. Thus, an annuity should only be purchased in an IRA or qualified plan if the client values other features of the annuity and is willing to incur additional costs associated with the annuity to receive such benefits.

Neither New York Life nor its representatives or affiliates provide tax or legal advice. Consult with a tax or legal advisor to discuss any questions or concerns that you have, such as the tax consequences of withdrawing funds or removing shares of an employer’s stock from a retirement plan.