Choosing the right plan to give you the amount of savings you need for your retirement years is something to which you need to give great consideration. This is because you do need to have enough money to allow you to continue to live in the style to which you have become accustomed and to be able to relax and enjoy life without financial worry. Two of the most common ways in which people plan to have money when they retire is through a 401k plan or a pension. You do need to understand the difference between the two so that you can plan your finances appropriately because there are pros and cons for both.
A 401k is the most popular type of retirement savings plan, but there are several different kinds to choose from. This type of plan is set up by the employer and a percentage of the pay is withheld each pay period and deposited into the fund. You also have the option of adding more to this amount if you wish, but the IRS caps the annual tax-free amount at $4000. You claim the amount paid into the plan on your income tax and do not have to pay taxes on this portion of your income. However, when you retire and start making monthly withdrawals from the fund, then you pay the applicable taxes.
There are penalties imposed if you decide to withdraw any money from a 401k plan before you reach the age of 59.5 years. Usually the IRS charges a penalty of 10% of the amount of money you have built up over the years. However, there are ways in which you can withdraw all or part of the money without incurring a penalty, such as if you become ill. There are very strict rules in place regarding early withdrawal.
You can borrow against your 401k plan as long as the amount of money that you borrow is repaid within 5 years. You are permitted to use your retirement plan in this way as collateral for a loan of up to $50,000 or 50% of the vested interest in the plan.
A pension plan is one that is set up by the employer and payments are made to the fund based on the income you earn. Pensions have always been in place as a means of saving for retirement and like a 401k plan, you do not pay any taxes on the money until you start to withdraw it. There is no tax benefit at all for you each year since you are not contributing to the plan. When you retire you have the option of withdrawing the money in a lump sum or receiving monthly payments.
What is the difference between the two?
The amount of money you would receive on a pension when you retire depends entirely on the amount of money that you earn when you are working and the length of time that you work for this employer. If you opt for a monthly payment, this amount will remain constant as long as you are drawing a pension.
In a 401k, the amount of money that you build up in the plan depends on the percentage you choose to have withheld from your pay each month. You do benefit from this at tax time because you don’t have to pay tax on this portion of your income. However, the money is taxed at the end when you start withdrawing it.
You can choose to have a lump sum payment with a pension but this option does not exist with a 401k plan. The amount of money you receive as monthly payments in both cases, though, does depend on the amount of money in the fund at the time of your retirement.
You don’t have any control over the contributions made to a pension plan, but you do with a 401k plan.