Deciding Between 401(k) or IRA Contributions

401(k) accounts evolved out of the movement by employers away from defined benefit pension plans and toward a scheme that is based upon the returns of money set aside for the benefit of employees.

It has been customary for a very long time for many employers to set aside money to help their people in retirement, where they would reserve part of the compensation paid out to them for this purpose. 401(k) accounts provide employers with a means to do this, where they will often contribute a percentage of the company’s money to a 401(k) based upon amounts the employee contributes themselves.

This percentage varies depending on the employer, where they may match contributions at a rate of 50%, 100%, 200% in some cases, or they may not do any matching at all. Even with a fairly modest 50% match, this makes contributing to a 401(k) very tempting indeed and there are few circumstances that would making contributing to an IRA instead a sensible choice.

The only possible exception to this in fact would be a situation where one is skilled enough at managing their own portfolio that they could do better overall without the match, by taking advantage of the much greater flexibility that IRAs provide, especially in times where we are mired in a bear market and the run of the mill funds that 401(k)s go with are doing poorly.

In today’s bull markets, this would be very difficult to do, to beat market returns when everything is rising significantly, and you likely won’t be able to make up for even a 50% match by trying to beat the market when it is moving up. It’s not that this can’t be done, but this takes a high level of expertise that is well beyond what most investors can ever hope for with their casual involvement.

Deciding Between 401(k)s and IRAs in Different Market Conditions

When the market is running up, it’s hard to beat the market, especially given that most investors are prone to making mistakes. A skilled professional may be able to take advantage of market pullbacks and time these well enough to beat bull markets, and people could learn to do that fairly well, but in this case, we need to beat these markets by a lot to make up for the fact that we’ve walked away from an instant 50% return on our money or more by passing up on the employer matching.

If we have $10,000 to invest and we take the match, we’ve now got $15,000 in our account, and therefore we’re pretty far behind at the outset, even though we may have many years to catch and pass the matched returns.

If, for instance, we have a time horizon of 20 years and we are confident that we can get an average return of 10% on our own instead of the 5% that we expect the market will deliver, as a 401(k) fund would provide, then we’ll end up with a total amount of $30,000. Our 10% a year ends up in the same place, and it has taken all this time go get there, an extra 5% over 20 years, and this gives us an idea of just what you’d have to do to even end up with the same amount of money.

At the time we’re deciding this though, we’re very likely not going to have enough experience or confidence to want to take this gamble, at least when we’re in a bull market. We can’t just look at the whole 20 years with its ups and downs, its bull and bear markets, and treat this as an all or nothing decision though, as there are times where it is easier to beat the market than others, during these bear markets that is.

We don’t need to put all our eggs in one basket though, and we can even use our IRA contributions to hedge our 401(k) money by contributing more to an IRA and take advantage of downward moving markets by using inverse ETFs.

Once money is in an IRA though, it should be left there, and although you can roll over IRA contributions to a 401(k) if your 401(k) plan allows it, this really doesn’t make a whole lot of sense unless you are looking to borrow the money through a 401(k) loan, you are seeking protection from creditors, or a few other reasons that aren’t common.

This is especially not a good idea if we’re looking to actively manage your investments, as we lose this flexibility if we move some of our money to the 401(k) without really receiving any benefit for this save for one of the conditions that this rollover may seek to take advantage of.

Hedging and Even Profiting from Bear Markets

We may be able to do a partial rollover from our 401(k) into an IRA though, as some 401(k) plans allow this, and this can be used as a real tool to manage things when we wish to reduce our risk exposure to bear markets in particular. This will all depend on the plan and this option isn’t often offered to those under 60, and we have to be aware of whatever particular rules that may apply here which vary by employer.

Still though, as we approach retirement, and certainly after we reach the age of 60, our investment time horizon is quickly shrinking, and it won’t take that big of a bear market to have us risking losing money from here to when we retire if we expose our retirement money completely to these risks.

401(k) investments are not adaptive at all, nor can they be, and if the market is tanking at a time where retirement is a few years away, and we don’t respond ourselves, we have no choice but to take the full hit of this.

The great majority of investors aren’t going to ever mess around with their retirement money by hedging, for a number of reasons, not the least of which is that they would have no real idea about what they are doing. There are fears of making some real mistakes and in this case that fear is justified.

We would need, at the very least, some basic market timing skills to aspire to use an IRA as a hedge here, and this involves being aware of what the larger trends are in order to be in a position to make decisions on where we are headed. This is not that difficult of a skill to gain though and we can just look at long term charts and get a good sense of market direction without any magical indicators or deep fundamental knowledge.

In fact, we don’t need any fundamental knowledge at all to do this fairly well at least. Everyone knows we’re in a bull market currently, and we’ve known this since 2009 since the market rebounded and we’re still going strong in 2018.

Focusing on intermediate and shorter-term trends can be a little trickier, but all we are really after here is to decide what the longer-term direction of the market is, and that’s not that hard to do. When we get the next bear market, it won’t be much of a secret, and you could ask 10 people on the street and all 10 will probably agree that we’re in a bear market, just like they all would agree that we’re in a bull market now.

The problem with most investors, almost all of them actually, is that they don’t see any opportunity to do anything differently when this happens, and are usually too scared to even consider the idea that they might look to change things up so they at least aren’t exposed to the full risk that bear markets involve.

We are so strongly biased toward the long side of markets that looking to go short is virtually unthinkable, but this does have its place at times and the way to put this plan into action with your retirement money is to have some of it in an IRA where you can do these things.

It’s not that we generally would want to throw all of our eggs on the short side of the market though, because we won’t always be right about these things, sometimes by deciding poorly and even when we decide very well. We therefore do want to be careful and the main idea behind this hedging is to reduce our risk exposure and losses when things aren’t moving up, and to be on the side of moving up with this IRA money when conditions dictate.

401(k) vs. IRA Without Employer Contributions

401(k) accounts do have their place even if your employer isn’t matching any of your contributions. The biggest one is the larger contribution room with our 401(k), although with all things being equal, in other words no real reason to prefer the 401(k), we should usually max out our IRA contributions first and then contribute the rest in our 401(k).

The majority of 401(k) plans do involve some sort of significant matching by employers though, and unless we’re in enough of a bear market that we expect to lose significantly more than half our contributions, or we are quite skilled in managing our own investments, we should be choosing to take advantage of the matching.

Rolling over some of our 401(k) money into an IRA to allow us to hedge markets better is another story though, and presents far more opportunities since we are both receiving the match and managing our positions, although we are going to need to be sure enough of ourselves to want to do this, and this is not something that we should be doing without any real knowledge of how to manage investments.

If there is no employer match though, and there are no good reasons why our money shouldn’t all go into a 401(k), then using our contribution limits in our IRA first is a good choice. This is especially true if we’re looking to contribute to a Roth IRA, which has the most flexibility of any retirement plan and will even allow us to take money out of it if we need to.

It really does come down to the employer matching as being the most significant reason by far to choose to contribute to a 401(k), at least as far as the amount that we could put into one or the other, the contribution limits of an IRA in other words.

There is an opportunity to move money around between 401(k)s and IRAs, but if there is a match, the most important thing is to take advantage of that and then decide what to do based upon the conditions that emerge over time and within what we are allowed to do by our 401(k) plan.

Beyond this match, IRAs do have more flexibility, and therefore we can say that they do have a natural advantage, although there are aspects of a 401(k) such as creditor protection in some cases or the ability to borrow the money that may have some preferring a 401(k) regardless.

We do need to be aware though that the strategies used by 401(k) investments all involve maximum risk exposure to the market with the stock component of it anyway, and if we are looking to manage that, we are limited as far as what we can do in a 401(k) and may indeed wish to look at managing things in an IRA where we have more freedom.

While even thinking about such things is going to be seen by most investors as well beyond what they would be willing to consider, if we can come to the understanding that the goal here with hedging isn’t to increase risk, it is to decrease it, we may then at least be open to this possibility and seek to learn how we may use such a strategy to our advantage.