What Is the Difference Between a Pension and 401k?

Employer-sponsored plans like pensions and 401(k)s are common ways to save for retirement. Understanding their fundamental differences is key to navigating retirement savings.

Contribution Mechanisms

Funding mechanisms are a primary distinction. Pension plans, often referred to as defined benefit plans, are typically funded entirely by the employer. The employer commits to providing a specific retirement benefit, usually calculated using a formula that considers factors such as an employee’s years of service and salary history. Employees generally do not make direct contributions from their paychecks to these plans.

In contrast, 401(k) plans, which are defined contribution plans, are primarily funded by the employees themselves. Employees elect to contribute a portion of their wages directly from their paycheck, either on a pre-tax basis or as Roth contributions. Many employers offering 401(k)s also provide contributions, often in the form of matching contributions or through profit-sharing contributions. Employer contributions can significantly boost overall savings.

Investment Control and Management

Investment control and risk differ significantly. For pension plans, the employer, or a third-party administrator hired by the employer, is responsible for managing the plan’s investments. These funds are typically pooled and invested with the goal of ensuring sufficient assets to meet future benefit obligations. The employer bears the investment risk, meaning that if investments underperform, the employer remains responsible for making promised payments to retirees. Employees generally have no direct control over how these pension funds are invested.

With 401(k) plans, investment control shifts to the employee. Employees select their investment options from a menu provided by the plan administrator, which commonly includes various mutual funds, exchange-traded funds (ETFs), or target-date funds. The value of a 401(k) account directly depends on the performance of these chosen investments. Therefore, the employee assumes the investment risk, meaning that poor investment performance could reduce the amount available for retirement.

Withdrawal and Payout Structures

Withdrawal and payout structures also differ. Pension plans typically provide a guaranteed income stream, most often in the form of an annuity. This means retirees receive regular, fixed payments for the remainder of their life, or for a specified period. Some pension plans may offer a lump-sum payout option, but the primary design is to provide predictable income. Spousal benefits are often available, allowing a surviving spouse to continue receiving a portion of the pension after the primary retiree’s death, though this typically results in a slightly lower initial payment.

In contrast, 401(k) plans offer greater flexibility in how funds can be withdrawn. Retirees can take a lump-sum distribution, make partial withdrawals as needed, or roll over the funds into an Individual Retirement Account (IRA) for continued tax-deferred growth and broader investment options. Withdrawals from a traditional 401(k) are taxed as ordinary income in retirement.

For Roth 401(k)s, contributions are made with after-tax dollars, and qualified withdrawals in retirement are tax-free, including earnings. Required Minimum Distributions (RMDs) apply to traditional 401(k)s and generally begin at age 73, though Roth 401(k)s are exempt from RMDs for the original account owner starting in 2024. Early withdrawals from a 401(k) before age 59½ typically incur a 10% penalty in addition to regular income tax, though some exceptions apply.