What is a Pension: Types of Plans and How They’re Taxed

It is vital to start planning and saving for work pensions early in your career to ensure financial security, monetary well-being, and peace of mind in retirement. The earlier and more seriously you begin, the better positioned you will be to enjoy a comfortable retirement.

What’s a pension? What types of plans exist, and how do they differ? Are pensions taxable, and if so, how? This article serves as your comprehensive guide to understanding retirement benefits.

What Is a Pension: Exploring Basic Concepts

In simple terms, a pension is essentially an agreement where an employer guarantees regular monthly payments for life once the employee reaches retirement age. When we say “pension,” we refer to the benefits paid to retirees. However, this starts with a pension plan, which obliges employers to make regular contributions to accounts designed to finance employee benefits upon retirement.

How does a pension work? In practice, employees must work for a company for a specified period, after which benefits will be transferred to them upon retirement. The amount they receive depends on the length of service and the amount of salary. If an employee has worked for a long time in two or more companies over their career, they may qualify for several pension plans and, therefore, several pension payments.

In general, most pension plans are typically employer-sponsored, although some options are employee-driven. You should also know that pension plans are changing significantly over time, with traditional pension plans becoming less common and being replaced by pension benefits that are less costly for employers.

Pension Plan Classifications

The pension plan definition covers much broader aspects than what we used to mean by traditional pensions. Let’s look at the features, advantages, and drawbacks for employees and employers that come with the most popular types of retirement plans.

Defined-Benefit Plans

This type of retirement plan is what we all think of when it comes to a traditional pension plan. A defined-benefit plan provides that an employer agrees to pay their employees a fixed monthly benefit for life upon retirement. The amount of the remuneration is based on certain factors, the main being the employee’s years of service and salary history.

The main advantage of a defined-benefit plan for employees is that for many years, they don’t have to manage their monthly income actively—employers bear full responsibility for their pension. As for employers, this option of pension plans is expensive and carries certain risks associated with guarantees and obligations to employees—if there are insufficient assets in the pension plan account, the responsibility for paying out the missing part lies entirely with the company.

Defined-Contribution Plans

These plans stand for shared retirement contributions by employees and employers. However, the defined-contribution plans do not guarantee a specific monthly retirement benefit. A defined contribution plan transfers risk from the employer, and in the event of an unsuccessful investment, the employee bears the entire loss.

Another disadvantage for employees under defined-contribution plans is that the majority of retirement savings responsibility falls on them. While employers may contribute to these plans, employees are required to make regular contributions, which, when viewed in the context of the total pension amount, may seem relatively small and potentially insignificant.

On the other hand, a significant advantage of defined-contribution plans is their flexibility. Employees can generally contribute as much as you want to their retirement accounts. Additionally, if they leave your job, they can take the full account balance—including their employer’s contributions—with them. For employers, these plans are financially advantageous since they come with lower costs and no long-term liability, unlike defined-benefit plans.

Other Retirement Savings Vehicles

An alternative to defined-benefit and defined-contribution types of pension plans are alternative options for retirement savings, such as IRAs and 401(k)s. And while a 401(k) is an employer-sponsored plan, an IRA is an individual retirement account that employees open themselves.

A 401(k) is an employer-sponsored plan in which workers contribute a portion of their paychecks automatically and put in the investments they choose from the plan options. Saving with a 401(k) provides that you benefit from those investments upon retirement.

If your employer doesn’t offer a 401(k), you can always open an individual retirement account. With this type of account, your employer won't be adding their contributions but allow you to invest in securities or financial instruments of your choosing.

As for the key differences between such forms of retirement savings as IRAs and 401(k)s from classic pension plans, it is that defined-benefit and defined-contribution plans are employer-sponsored, while IRAs and 401(k)s rely on employee contributions for funding. And even though neither IRAs nor 401(k)s fixed monthly income for life, they offer greater flexibility and control over your pension savings. Employees can decide how much to save and where to invest, empowering them to tailor their retirement strategies.

ERISA: A Key Retirement Law

When exploring various pensions types, it’s essential to understand ERISA, or the Employee Retirement Income Security Act. Established in 1974, this law safeguards employees’ retirement assets by setting clear guidelines for fiduciaries companies that sponsor pension plans.

The role of this law cannot be underestimated, as its main purpose is to ensure that all employees receive the benefits they’ve been promised and to prevent unfair practices, such as discrimination based on the length of tenure, gender, age, or race.

Every company has to inform an eligible employee to a required degree about investment options and employer contribution matching.

ERISA plays a vital role in maintaining fairness and transparency in retirement planning, giving employees confidence in the security of their benefits.

Lump Sum vs. Annuity

When discussing types of pension, we should mention two withdrawal approaches—lump sum and annuity.

An annuity refers to several payments that a retired individual receives annually, quarterly, or monthly (most common). A lump sum is when a retiree obtains all their money at once. Both of these withdrawal options are offered under a defined-benefit pension plan.

So, which one of them is better? Each one has some pros and cons, and it depends on individual circumstances, financial goals, and risk tolerance.

For example, annuities envisage payments for the rest of your life, but you will have less freedom in how you can spend your money. However, you should also consider that annuities may fall short during unexpected large expenses.

A lump sum, on the other hand, allows you to cover debt or other large expenses. At the same time, there is a risk of depleting funds prematurely.

Both options have advantages and drawbacks, so retirees should carefully evaluate their financial plans before deciding.

Tax Rules for Pension Income

Taxation rules for retirement plans are pretty straightforward and are usually divided into two key stages:

• Taxation During Accumulation: Most employer-sponsored pension plans, including defined-benefit and defined-contribution options, are tax- and pension-compliant, meaning they have tax-advantaged status for both employers and employees. The funds that employees contribute to the pension plan account come “off the top” of their salary, which effectively reduces the employee’s taxable income and, therefore, the amount they must pay to the IRS. Money saved in a retirement account grows tax-deferred—as long as the money remains in the account, it is tax-free.
• Taxation at Withdrawal: In most cases, withdrawals are subject to income taxes—after retirement when the account owner begins withdrawing money from the retirement plan, they must pay federal income taxes. If the funds were contributed after taxes, the pension will only be partially taxed.

Understanding these tax implications is crucial for maximizing retirement savings and minimizing tax liabilities.

Final Thoughts

There are two main types of work pension plans: defined benefit and defined contribution options. When it comes to defined-benefit plans, they are traditional pension plans that promise a certain monthly retirement benefit. Defined-contribution plans, on the other hand, expect benefits to be determined by contributions and investment performance of the plan.

In addition, there are other forms of retirement savings, such as IRAs and 401(k)s, which are employee-sponsored and do not provide a guaranteed fixed monthly income for life. However, they offer greater flexibility and control over retirement savings. By understanding the nuances of each option, employees can make informed decisions to secure their financial future and achieve a comfortable retirement.