Pension Plan

Written By
Paul Tracy
Updated August 5, 2020

What is a Pension Plan?

A pension plan is an arrangement to provide employees with an income when they are no longer earning a regular income from employment.

How Does a Pension Plan Work?

A pension plan is usually a type of retirement plan that gives employers the opportunity to make a contribution to a fund set aside for an employee's future benefit.  The pool of funds is invested on behalf of the employee, on a tax exempt basis, and is intended to yield a stream of payments to the employee upon retirement.

By allowing the employer to make the payment into the employee's pension plan in this way, the employee is deferring a portion of his or her income to a future time.
  
There are two main types of pension plans.  One type is defined-benefit plans, where the employee receives a specific amount upon retirement regardless of the performance of the investment pool.  The other type is a defined-contribution plan, where the employee receives an amount based on the performance of the investment pool.

In accordance with the US Internal Revenue Service code, the amount of the tax-exempt contributions into a pension plan is limited based on the income levels of the employee. 

Why Does a Pension Plan Matter?

Pension plans can include a variety of types of contributions in addition to cash payments.  For example, a pension plan may include profit-sharing plan, a stock bonus plan (usually deferred until retirement so that the contribution is taxed at the retirement tax rate) and even an employee stock ownership plan.