For many people, retirement planning is one of the biggest financial goals to reach, and fortunately, there are many ways to get there.
Two common ways to save for retirement are retirement plans and pension plans. Each can provide you with significant funds in your golden years, but each has distinct features that suit them to different types of savers as they move through the phases of retirement.
This article will explain retirement and pension plans, then examine a few key differences between each.
What is a Retirement Plan?
A retirement plan is a savings plan you set up and contribute to regularly while working. Workplace plans, such as 401(k)s, are set up through your employer, and you fund these with pretax paycheck deductions. This helps to potentially reduce your tax burden and save more.
Meanwhile, you can set up individual retirement accounts, or IRAs, through an outside broker.
You invest contributions into securities, like stocks, bonds, and mutual funds. Workplace plans offer fewer investment choices but higher contribution limits. IRAs have lower contribution limits but a wider investment selection. Both give you opportunities to potentially build wealth faster, but you must guard against losses.
Once you reach retirement age, you can withdraw from these accounts to cover living expenses.
What is a Pension Plan?
A pension plan is an employer-sponsored plan that pays a guaranteed income stream in retirement, regardless of market fluctuations. The employer funds the plan and manages the investments.
Employers calculate your pension's using several factors, such as:
- Years working for the employer
- The employee's salary
Retirement Plans vs. Pension Plans
Here are four key differences between retirement plans and pension plans:
Retirement plans make the employee fund the plan through paycheck deductions. Many employers match a specific portion of employee contributions, but the employee contributes most of the funds.
Pension plans are primarily funded by the employer. The employer sets aside funds to contribute to the pension plan.
Employees bear the risk and responsibility of contributing to retirement plans and investing the funds. They have more control, potentially leading to a larger account and a higher income. However, they can also experience market losses.
Employers are responsible for investing and managing pension funds. They bear all associated risks. Employees get a guaranteed income stream, but it could potentially be smaller than what they could receive with a retirement plan.
Retirees must take Required Minimum Distributions (RMDs) from pretax retirement plans. This minimum yearly amount you must withdraw in retirement is based on life expectancy and account balance.
However, you can withdraw more than the RMD. Furthermore, you receive the payout as a lump sum. You must manage your withdrawal strategy so your funds last through retirement.
Pensions pay a guaranteed income stream income for life. This can provide greater financial security, but you can't withdraw more in a particular year if you need additional funds.
IRAs stay with you no matter where you go, whereas workplace plans, like 401(k), may need to be rolled over to an IRA.
Pension plans do not always follow you. You may have to stay with the employer for a certain timeframe to receive retirement income. However, some pensions let you take a lump sum if you leave.
The Bottom Line
There is no "best" plan for everyone's retirement goals. All plans have their pros and cons, suiting them to different employees.
Retirement plans offer more control, which can help you potentially build more wealth and tailor your savings to your desired lifestyle. However, you bear more risk and responsibility. If you're more hands-on, a retirement plan may be best.
Pension plans offer less control and may provide a smaller retirement payout depending on the your investment strategy. You must stay with an employer to maximize the pension. However, you get a guaranteed income stream. If you're more hands-off, a pension plan could suit you better.
It's crucial to weigh the pros and cons of each carefully and seek out a financial advisor if you need help developing a retirement strategy that fits your needs.
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