Is a 401(a) a Pension? Comparing the Key Differences

A 401(a) plan refers to a section of the Internal Revenue Code (IRC) that outlines requirements for a retirement plan to receive favorable tax treatment. The term “401(a) plan” can create confusion because it encompasses various qualified employer-sponsored retirement plans, including defined benefit (pension) and defined contribution plans. This article clarifies 401(a) plans and distinguishes them from traditional pensions.

Understanding 401(a) Plans

Internal Revenue Code Section 401(a) specifies the criteria a retirement plan must satisfy to be considered “qualified” by the IRS, which grants it certain tax advantages. This section functions as an umbrella term, meaning numerous employer-sponsored retirement plans, such as 401(k)s, profit-sharing plans, and money purchase plans, must adhere to 401(a) rules to achieve qualified status. These plans assist employees in saving for retirement, allowing contributions and earnings to grow tax-deferred.

They are typically offered by governmental entities, educational institutions, and some non-profit organizations, though certain private sector employers may also utilize them. The employer often maintains significant control over the plan’s structure, including contribution rates and investment options. While some 401(a) plans might allow employee contributions, they primarily involve employer contributions, which can be mandatory or non-elective.

Distinguishing 401(a) from Traditional Pensions

A “traditional pension” is formally known as a defined benefit (DB) plan, characterized by the employer’s promise to provide a specific, predetermined monthly benefit during retirement. This benefit is often calculated using a formula that considers factors like the employee’s salary history and years of service. The employer assumes the investment risk in a defined benefit plan, meaning they must ensure sufficient funds exist to pay promised benefits, regardless of investment performance.

While some 401(a) plans are defined benefit plans, the term “401(a) plan” frequently refers to defined contribution (DC) plans that fall under this code section. In defined contribution plans, employer and sometimes employee contributions are defined, but the future retirement benefit is not guaranteed. The employee bears the investment risk, as the final account balance depends on contributions and investment performance.

Defined contribution plans specify contributions and have individual accounts. Defined benefit plans do not involve individual accounts; instead, funds are pooled, and the employer manages investments. Payouts from defined contribution plans usually involve lump sums or rollover options based on the accumulated account balance. In contrast, defined benefit plans commonly provide guaranteed lifetime annuity payments to retirees. The distinction between a defined benefit plan and a defined contribution plan is the key differentiator, rather than the 401(a) code section label itself.

Key Aspects of 401(a) Plan Participation

Participation in a 401(a) plan involves several practical considerations for employees. Contributions can originate from the employer, employee, or both. Employer contributions are frequently mandatory and determined by a specific formula, such as a percentage of compensation or based on company profits. Employee contributions may also be permitted or required, depending on the plan’s specific design.

Vesting is when an employee gains non-forfeitable ownership of employer contributions. While employee contributions are always immediately 100% vested, employer contributions typically follow a vesting schedule. Common vesting schedules include “cliff vesting,” where full ownership is granted after a specific period, or “graded vesting,” where ownership gradually increases over several years. For instance, a common graded schedule might involve 20% vesting after two years, increasing to 100% after six years.

Funds can generally be accessed upon retirement or termination of employment. Common payout options include lump-sum distributions or rollovers to an Individual Retirement Account (IRA) or another qualified retirement plan. Distributions are generally taxable as ordinary income upon withdrawal. Withdrawals made before age 59½ are typically subject to a 10% additional IRS penalty, unless an exception applies. Participants are required to begin taking distributions, known as Required Minimum Distributions (RMDs), by age 73.