Rolling your 401k: Contributory IRA vs. Rollover IRA

In an ideal world you would start your working career with a great company in your early 20s, steadily climb the corporate ladder, retire at age 65, and draw a sufficient income from your accumulated 401k account to live happily ever after.

Unfortunately, that’s not how the real world works. If you are like most people, you will change careers, or at least companies, several times. Each time, you'll be faced with the question of what to do with your accumulated 401k benefits.

You will likely have a few choices: keep your 401k with your old employer (sometimes possible), roll the proceeds into your new employer's 401k plan, or put them directly into a self-directed IRA at a brokerage firm of your choice.

Since leaving your 401k with your ex-employer has no benefits whatsoever and most employers will prefer you transfer out anyway, that leaves only the last two as viable options:

1. Roll your 401k proceeds into the new employer's 401k plan of (if allowed)

This is the most painless solution and the one that does not require much decision making. While this is certainly acceptable, there is a bigger picture.

The ultimate goal of having a 401k plan is to provide you with a comfortable retirement. To accomplish this you really need a wide variety of investment choices and the opportunity to move among them in response to market variations.

Most 401ks are limited to maybe 15 mutual fund choices which rarely change, even if market behavior dictates they should. Additionally, the canned advice provided through plan sponsors is generally not terribly useful.

The only benefit to this type of rollover is that if your plan has a loan provision, you’ll be able to borrow funds easily.

2. Roll your 401k proceeds into a self directed IRA

This is the preferable solution for most people, and with it you again have two choices: roll your 401k into a “Contributory” or a “Rollover” IRA.

Contributory IRA:
Once you roll your proceeds into this type of IRA, you may still contribute annually if you qualify (check with your accountant). However, the 401k portion can no longer be rolled back into another 401k with a new employer, should you ever want to do that. So you eliminate the possibility of using the loan provision with those funds. While it is possible to borrow against an IRA, it’s more limited than borrowing against an employer 401k. Check with your tax preparer for details.

Rollover IRA:
This type of IRA allows you the most flexibility. You may roll the proceeds back into a 401k plan if you want to utilize a loan provision. However, for tax reasons you should not make annual contributions to this IRA. If making annual contributions becomes important to you, simply open another contributory IRA.

Since Rollover IRAs are usually set up at a brokerage firm, you’ll have access to their entire universe of mutual funds. With this type of IRA, you can also employ an independent investment advisor to manage the account for you. (Yes there is a cost for that, but an effective advisor will more than make up for that in greater returns than you would get without him or her.)

Most of my clients have found that the investment results we've obtained with their personal IRAs were far superior to those yielded by their employer 401k plans or their personal investing efforts. This has been mainly due to a combination of better choices and a methodical approach to investing which has kept my clients in the market during good times and out of it altogether during severe declines.

Bottom line: Rollover IRAs offer opportunities to maximize benefits and provide flexibility not usually available with employer 401k plans.