Can an Employee Roll Over a 401(k) Into a Self-Directed IRA While Still Employed?

The rollover and tax rules don’t care whether your IRA is self-directed, but it’s an important issue for you. All IRA’s require a custodian. In a self-directed IRA, your custodian will allow you to buy any type of asset not barred by the IRS. Forbidden assets include life insurance plans and collectibles, except for certain forms of precious metals. If your IRA is not self-directed, your custodian might limit your purchases to the assets it sells. For example, if the custodian is a mutual fund company, you may be restricted to the funds the custodian offers. Federal agencies and others have issued warnings about the risk of fraud arising from self-directed IRAs.

You can take 401(k) distributions if employment is severed. Alternatively, you can withdraw money if you become disabled, suffer a financial hardship, reach age 59 1/2, belong to a discontinued plan, or are a reservist called to active duty for at least half a year. You can also take substantially equal periodic payments from your 401(k). Unless you roll over your withdrawals into an IRA or another employer plan, you must include the distribution in your taxable income. If you are younger than age 55, you also may have to pay an early withdrawal penalty of 10 percent.

Internal Revenue Service rules determine whether or not you can roll a 401(k) distribution into an IRA. Normally there is no problem performing the rollover if you leave the job. However, you may not roll over a distribution you receive after age 70 1/2. Some other distributions don’t qualify for rollover, including ones arising from financial hardship, required minimum distributions, substantially equal periodic payments, and the return of nondeductible contributions. You may not roll over loans from the plan, dividends on employer securities, and money representing the cost of life insurance within the plan.

Your employer must withhold 20 percent of your plan distributions for income taxes, even if you deposit the money into an IRA. However, you can avoid the withholding if you arrange for a trustee-to-trustee transfer. If you perform your own rollover, you must complete the process within 60 days of receiving the money or the IRS will treat it as a taxable distribution. You avoid income taxes and the 10 percent early withdrawal penalty when you roll over 401(k) distributions. Even if you’re younger than age 59 1/2, you might evade the 10 percent penalty if the withdrawal is due to disability, substantially equal periodic payments, job severance, a divorce settlement, certain medical costs and reservist’s active duty.