Updated: Sep 17, 2019
A huge part of "adulting" is setting ourselves up for retirement. When we have the option to invest in our employer's retirement plan, it is important to note the terms of the plan. 401(k) plans, 403(b) plans, and pension plans all are subject to different terms. Large government agencies and a handful Fortune 500 companies tend to offer pension plans, nonprofit organizations and Churches often offer the 403(b) plan, and small and mid-sized business tend to offer the 401(k). All plans invest employee funds for future payout. The differences, however, are quite significant.
Section 401(k) of the IRS code allows employers to establish a trust for the exclusive benefit of employees. Contributions made into the trust are invested and can be paid out to employees as early as age 59 1/2. Any employee withdrawals made before age 59 1/2 will incur a 10% tax penalty unless the withdrawal meets certain IRS exceptions, or the specifc plan allows for early withdrawal. For those fortunate enough to delay their 401(k) distributions, a required minimum distribution (RMD) must be withdrawn by age 70 1/2.
Employee contributions into the plan are made pre-tax which means an employee's taxable income is reduced by the amount contributed. Employees get to choose the specific investments for their contributions from a pool of investment options chosen by the employer. This puts the employee in charge of the investments and subject to the risks of the market.
Employees under age 50 can only contribute $19,000 into the 401(k) plan in 2019. Anything more than that is considered an "excess contribution" and will incur a 6% excise tax if not withdrawn before the tax filing date.
One of the coolest features about these plans is that they allow employers to match employee contributions. To maximize an employee's investment, most financial planners would recommend contributing the maximum amount every year to incur the highest employer match (if the company's plan offers employer matching).
The 403(b) and 401(k) plans are quite similar. The main difference between these two retirement plans is that for-profit entities are not eligible to offer the 403(b). Schools, hospitals, nonprofit organizations, and religious organizations often offer the 403(b) plan to their employees.
Similar to the 401(k) plan, employee contributions into a 403(b) are made pre-tax. The terms of a 403(b) plan are similar to a 401(k), although the contribution limits into a 403(b) are sometimes higher for employees with a certain amount of years in service. In some cases, 403(b) investment options might be more limited than those of a 401(k).
Different from 401(k) plans that are mostly governed by the IRS, pension plans are governed by the IRS and the Department of Labor (DOL). The correct term for the pension we are referring to is "defined benefit plan." The DOL website states:
A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service - for example, 1 percent of average salary for the last 5 years of employment for every year of service with an employer. The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).
With a pension plan, the employer puts their finances at risk by guaranteeing payment to employees in spite of market performance. This is different from the 401(k) plan in which the employee has control over the investments and puts their own contributions at risk. The amount paid to each employee is a formula that can be based on amount of time employed, age, and other factors.
Rules for withdrawal are similar to those for the 401(k). Some defined benefit plans allow for early withdrawal.
Each plan has pros and cons summarized in the table below. The pension plan is a guaranteed payout amount which might make some employees more financially secure. The 401(k) has more flexibility and risks which could allow for high payouts when retirement hits. Whichever plan is available to you, make sure you participate and set yourself up for financial independence as you approach retirement age.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers before engaging in any transaction.