If you're ready to start building your retirement nest egg, you need to know what your savings options are. Depending on your employer, you might be able to contribute to a 401(k) plan or enroll in a traditional pension plan. Both types of plans can help you sock away cash for your golden years, but they work very differently. Weighing the pros and cons can help you choose the right one for your retirement strategy.
Who Can Contribute
A traditional pension plan is a type of defined benefit plan recognized under the Employee Retirement Income Security Act of 1974. Defined benefit plans guarantee you a specific amount of money once you retire. Under federal law, only employers are allowed to kick in contributions to a defined benefit pension plan. ERISA also recognizes 401(k) accounts, which are a type of defined contribution plan. With this type of plan, you fund your savings through regular payroll deductions. Your employer has the option of matching a percentage of what you put in, but is not required to.
The IRS determines how much money can be contributed to defined benefit pension accounts and 401(k) plans. These amounts are adjusted periodically for inflation. As of 2013, the annual benefit limit for a defined benefit plan was $205,000. The most you could put in your 401(k) plan was $17,500, with an additional catch-up contribution of $5,500 for employees over age 50. If your employer offers to match the money you put in your 401(k), your total annual contributions are capped at $51,000 for 2013.
Defined benefit plans are designed to give you a steady source of income in your golden years. Typically, benefits are paid out as a monthly annuity that lasts until you die. Depending on your employer, you may also have the option of getting all your pension plan money in one lump sum when you retire. The IRS usually doesn't allow you to take money out of your 401(k) without a penalty unless you're 59 1/2 or older. There are some exceptions if you become disabled, experience a financial hardship, leave your job or if your employer terminates the plan. When you retire, your plan administrator may let you take a lump sum or sign up for monthly annuity payments. You could also roll the money over into another qualified retirement account without a penalty.
Taxes on Withdrawals
Pension payments are fully taxable or partially taxable, depending on the type of plan you're enrolled in. According to the IRS, money you receive from a pension is fully taxable at your regular income tax rate if you don't have an interest in the contract, your employer didn't withhold contributions from your salary, or you received all of your contributions back tax-free in previous years. Unless you qualify for a hardship withdrawal, your 401(k) benefits are also taxable once you start taking the money out. You'll also have to pay a 10 percent early withdrawal penalty if you're under age 59 1/2.
- U.S. Department of Labor: Frequently Asked Questions About Pension Plans and ERISA
- Internal Revenue Service: IRS Announces 2013 Pension Plan Limitations
- Internal Revenue Service: 401(k) Resource Guide - Plan Participants - General Distribution Rules
- Internal Revenue Service: Tax Topic 410, Pensions and Annuities
- Stockbyte/Stockbyte/Getty Images