In 2022, hearing about a pension plan brings on a feeling of nostalgia or of a simpler time. Today’s people are becoming more and more responsible for their own retirement savings due to employers no longer offering this type of benefit.
These days, pensions are typically only offered by the government or larger companies. And, in many other cases, the 401(k) has replaced the pension option for many other employers.
But if you are one of the lucky few who will be receiving pension payouts during retirement, it’s important to know:
- what a pension is
- how a pension works
What Is A Pension Plan?
A pension plan is a retirement plan that requires an employer to make contributions into a pool of funds set aside for an employee’s future benefit. The pool of funds is invested on the employee’s behalf, and the earnings on the investments generate income to the worker upon retirement. Pensions are considered a form of a defined benefit plan, as they provide a set level of guaranteed income during retirement.
In addition to an employer’s required contributions, some pension plans have a voluntary investment component, which allows employees to contribute part of his/her current income into an investment plan to help further fund their retirement. Employers could also choose to match those funds as well, up to a certain dollar amount.
Depending on the plan, pension benefits may also be inheritable by a surviving spouse or children.
Can I Still Get My Pension If I Leave My Company?
If you leave your job before your pension benefits “vest,” you will typically not have access to the money in your pension.
Vesting schedules come in two forms: cliff and graded. If you don’t know the vesting schedule for your benefits, be sure to ask your employer.
What is Cliff Vesting?
- Cliff vesting is when you have no claim to any company contributions until a certain deadline (for example, 5 years).
What is Graded Vesting?
- Graded vesting means that a percentage of your benefits vest each year, until you reach 100% vesting. So, if you leave a company after one year, you might leave with nothing. Or, you might leave with just 25% of your pension available to you.
How Much Will I Receive From My Pension When I Retire?
A formula determines how much pension income you will receive once you are retired. The formula follows specific rules set by the Department of Labor that specify exactly how much your employer should be contributing to your investment fund.
The factors determining how much you would receive from your pension are:
- Your age
- Number years of service with the company offering the pension
- Your compensation
More years usually means more money. A worker with decades of tenure with a company or government may be entitled to 85% of their salary in retirement. One with less time under their belt, or someone who has a “less generous” employer, may only receive 50%.
Will I Pay Taxes On Pension Payouts?
Yes, you will incur federal taxes on any pension payouts that you receive. Some states also apply state-level taxes to your pension payouts as well.
States that exempt pension income entirely for qualified retirees are
- Alaska
- Florida
- Illinois
- Mississippi
- Nevada
- New Hampshire
- Pennsylvania
- South Dakota
- Tennessee
- Texas
- Washington
- Wyoming
A credit is provided in these states for a portion of pension income:
- Alabama
- Arkansas
- Colorado
- Delaware
- Georgia
- Hawaii
- Iowa
- Kentucky
- Louisiana
- Maine
- Maryland
- Michigan
- Missouri
- Montana
- New Jersey
- New Mexico
- Ohio
- New York
- Oklahoma
- Oregon
- South Carolina
- Utah
- Virginia
- Wisconsin
States that fully tax pension income are:
- California
- Minnesota
- Vermont
- Idaho
- Connecticut
- Nebraska
- West Virginia
- Rhode Island
- Kansas
- North Carolina
- Massachusetts
- Arizona
- Indiana
- North Dakota
However, if after-tax cash was contributed to a pension, a portion of those proceeds could be considered tax-free (your employer or a professional tax accountant can provide clarity on this based on your specific plan).
In addition, an employee with a disability may also see taxes waived on his or her pension plan proceeds in retirement.
Should I Take Lump-Sum Or Steady Payouts From My Pension?
Hate to say this… but how you should take your payouts really depends on your individual situation.
If you take steady payments (sometimes referred to as ‘Life Annuity’), you won’t have to worry about dividing up your money or trying to invest your money yourself. It’s most similar to receiving a paycheck each month… which you’re already used to getting from your employer.
If you decide to take your money in one lump-sum, it will be up to you to manage your own money and not be tempted to spend too much today and end up having nothing left down the line.
On the other hand, taking your money now allows you to gain control of your investments so you won’t always have to worry about how the company is doing (because if your company goes belly-up, your pension may be reduced). This may also be a good option if estate planning is important to you, because you would have the option to go ahead and set some of the funds aside to leave for your loved ones after you pass away.
Can You Get Social Security Benefits In Addition to Pension Payouts?
Sometimes. If you work for or have a pension from a government employer, you may not be eligible to receive Social Security benefits, or may only get partial benefits.
This is because some public-sector workers do not have funds taken out of their paychecks for Social Security.
Is a Pension Plan or 401(k) Better?
The answer to this question truly depends on your individual needs.
Both pensions and 401(k)s enjoy tax-deferred growth.
With a 401(k) plan you have the ability to increase your contributions, while with pension plans, your contribution is set.
Some 401(k)s come with employer matches, in which your employer will match any contribution you make up to a set limit. With a 401(k), your employer will give you a menu of options from which you’ll choose how to invest your contributions.
A pension plan relies on the employer to make contributions and investments on behalf of their employee. This means all of the guess work and investment decisions (i.e., what stocks, funds or bonds to pick) are not your responsibility as an employee. This is both a benefit and a disadvantage. You don’t have to worry about choosing the right investments for your pension. But, you’re also vulnerable to any investing mistakes your employer might make.
If you are someone who wants more control, a 401(k) or an IRA may be a better option for you. You can also open a deferred or immediate annuity, where you make a one-time lump sum payment in return for guaranteed payments in retirement.
Want to learn more about other retirement plan options? Read our article here.
Kate writes about retirement benefits for retirementinsurance.org. She has a Masters Degree in Social Work (MSW). She has over a decade of experience in assisting elderly and disabled populations navigate governmental and private programs to obtain the monetary assistance they need to lead better lives. As she watched her parents begin their own retirement journeys and navigate similar systems to obtain Social Security, Medicare and other retirement benefits, she gleaned a further personal knowledge about the topic and is eager to share what she has learned with others.