401(k) Plans versus Traditional Pensions

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401(k) Plans versus Traditional Pensions

The pension is fast becoming a thing of the past. These days, more and more companies are adopting cryptically titled retirement packages called 401(k) plans.

A 401(k) plan (as well as its cousin, the 403(b) plan) is a defined contribution plan. This means that the amount you receive in retirement is based on the amount that you (and your employer, if there’s a match available) contribute to the plan, in addition to the investment returns you earn on those contributions.

In contrast, "defined benefit plans," such as pensions, generally pay a guaranteed sum based on your wages and years of service.

As investment programs, 401(k) plans have several great features:

They’re automatic

You can’t forget to invest—your employer deducts your contribution from each paycheck. This forces you to invest regularly, even when the markets are down.

They invest pretax dollars

Your investment doesn’t take as big a bite from your paycheck as you might imagine, because you’re investing pretax dollars in your 401(k) plan. As a result, a $100 contribution doesn’t result in a $100 reduction in your take-home pay. In fact, you can save money on your income taxes now by investing in your 401(k): The income figure that the IRS uses is income after 401(k) contributions.

You don’t pay taxes on investment gains until later

Mutual funds make distributions, bond funds pay income, and equity funds often distribute capital gains. Unless you hold your mutual funds in a tax-deferred account (such as a 401(k) plan), you’re responsible for paying taxes on these distributions, as well as on any gains you realize by selling an investment.

By investing in a 401(k) plan, however, you don’t have to come up with more money for the tax man right now. You won’t pay taxes until you begin withdrawing money from the plan.

Many employers match all or part of your contribution

For every dollar you contribute to your plan, your employer might invest an additional 50 cents. Some plans are more generous and match "dollar for dollar" on at least a portion of the employee contribution. That’s like getting an instant 100% return on your investment.

Say you earn $35,000 a year and contribute 10% of your income to your 401(k) plan. If your employer matches 100% on the first 4% of your contribution, your total contribution to the plan is $4,900. That’s $3,500 from you and $1,400 from your employer. Over 10 years time, that $1,400 per year really adds up.

Given that this is really free money, try to contribute at least enough to your 401(k) plan to get the full employer match.

You control your own investments

401(k) plans have shifted the risk of getting good investment results from employers to employees. You choose your own investments from a menu of options. 401(k) plan participants have greater freedom to control their financial futures than pension recipients do.

If you’re an aggressive investor with a long time horizon, you can opt for the plan’s racier options. Or, if you’re near retirement age, you can be as conservative as the plan allows. It’s up to you.