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

To achieve financial security, monetary well-being, and peace of mind when you retire, it is important to start planning and saving for work pensions early in your career. How early and how seriously you start doing this will determine whether you will be able to ensure a comfortable retirement.

What’s a pension, and how do pensions work? What types of plans are there, and how do they differ? Are pensions taxable, and according to what principles? Our article is your in-depth guide to fully understanding retirement benefits.

What is a Pension: Exploring Basic Concepts

In simple terms, a pension is an agreement in which the employer guarantees a certain amount of monthly payments for life once the employee reaches retirement age. When we say “pension”, we are actually talking about a benefit intended for a pensioner. But before that comes a pension plan, which stands for an employee benefit that obliges the employer to make payments at regular intervals into accounts to finance employee benefits upon retirement.

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

In general, retirement plans are typically employer-sponsored, but there are also employee-sponsored options. You should also know that pension plans are changing significantly over time — traditional pension plans are becoming extremely rare and are being replaced by pension benefits that are less costly for employers.

Pension Plan Classifications

The pension plan definition covers much broader aspects than just what we used to mean by traditional pensions. Let’s look at the features, advantages, and disadvantages 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 specified amount for life on a monthly basis when they retire. The amount of the remuneration is based on certain factors, the main being the employee’s work experience in the position and the amount of salary.

The main advantage of a defined-benefit plan for employees is that for many years, they do not actually have to worry about monthly income — employers take responsibility for their pension. As for employers, this option of pension payments 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, but they 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 is that the bulk of pension savings is assigned to them in one way or another, and employees only make accompanying contributions, which in the context of the overall pension amount may turn out insignificant.

The key benefit of a defined-contribution plan is that you can usually contribute as much as you want to your retirement account, and if you leave your job, you can take the entire account balance along with the amount your employer has contributed. Such an approach also relieves employers of liability and guarantees, and financing such a plan is much cheaper than a defined-benefit.

Other Retirement Savings Vehicles

An alternative to defined-benefit and defined-contribution types of pension plans are other forms of 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) plan works by having workers contribute money from 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 when you retire.

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 main 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 sponsored by the employer, while IRAs and 401(k)s are funded by the employee. And even though IRAs and 401(k)s don’t provide a guaranteed fixed income for life, they offer more control over your pension savings, as well as where you invest and how much you save for retirement.

Tax Rules for Pension Income

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

• Taxation during accumulation. Most employer-sponsored pension plans, such as 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 is kept 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.

Final Thoughts

There are two popular 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.