A self-directed 401(k) allows individuals the ability to decide how they want to invest their pre-tax contributions for retirement. Instead of being limited to pre-approved funds generally associated with traditional 401(k) plans, a self-directed 401(k) lets an individual choose where they’ll invest their money.

A 401(k) is often the main, if not only, retirement account for many Americans. Given the significant role a 401(k) plays in the retirement plans of Americans, it’s only logical that they want a higher degree of control over how it performs.

Key takeaways: 

  • Self-directed 401(k) plans are qualified, business-sponsored retirement plans that are approved by the IRS.
  • Self-directed 401(k) plans allow individuals to have more control over the types of investments being made with their money.
  • Self-directed 401(k) plans have the same contribution, distribution, and rollover IRS rules that traditional retirement plans have.
  • Self-directed 401(k) plans can be funded via payroll contributions, rollover funds, and profit-sharing.

What is a Self Directed 401(k)?

A self-directed 401(k) is a qualified retirement plan that is sponsored by a business and approved by the IRS. It also has to follow the same requirements and rules as other 401(k) plans. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 resulted in significant changes being made to the IRS code, including lowering taxes for self-directed 401(k) plans and other qualified plans.

With a self-directed 401(k) Individuals can direct their retirement savings into a variety of investment avenues, including precious metals, money lending, and private placements. They have complete flexibility to invest in anything they wish.

As with anything, there are advantages and disadvantages to self-directed 401(k) plans that are important to understand and consider.

Advantages of Self-Directed 401(k) Plans

A self-directed 401(k) offers many of the same benefits as traditional 401(k) plans. They have the same pre-tax savings benefits via automated payroll deduction and are subject to the same rules and regulations regarding contribution limits, withdrawals, and rollovers.

The biggest advantage individuals are drawn to with self-directed 401(k) plans is the increased level of control they offer. Instead of being limited to the investment decisions made by a plan administrator, individuals have complete power in deciding where they’ll invest. Another advantage is the number of investment options available to choose from. Traditional 401(k) plans usually limit individuals to premade funds. Self-directed 401(k) plans allow individuals to invest in anything they like including stocks, bonds, tax liens, and real estate.

Disadvantages of Self-Directed 401(k) Plans

Some disadvantages come with self-directed 401(k) plans. There are often more fees associated with self-directed 401(k) plans based on the types of investments individuals choose. The type of investments usually favored by Individuals with a self-directed 401(k) plan typically result in more frequent trades than seen with index and mutual funds used with traditional 401(k) plans. Increased trading frequency can eat into the overall return rate.

It takes a high level of expertise for a self-directed 401(k) plan to perform well. Even professionals with years of experience routinely underperform index funds that look to mimic the overall market performance. Individuals also need to consider if they have enough time to devote to a self-directed 401(k). Most individuals are better off with low-cost index funds that can be set and forgotten about.

Self-directed 401(k) plans may be ideal, though, for sole proprietors, contractors, and self-employed consultants.

IRS Rules For Self-Directed 401(k)

The same rules and regulations apply to self-directed 401(k) plans as traditional 401(k) plans. It’s essential for individuals to know and understand these rules before taking over their employer-sponsored plan or establishing their own.

Annual Contribution Limits

For 2019, the maximum amount individuals under the age of 50 could deduct from their taxable income and put into their self-directed 401(k) account was $19,000. Individuals over the age of 50 were also eligible for a $6,000 “catch up” contribution. These amounts increased to $19,500 and $6,500, respectively, for 2020.  These limits regularly increase to account for inflation.

If an individual only worked for one company during a calendar year they shouldn’t have to worry about going over the 401(k) contribution limit as the employer generally calculates this for employees. However, if an individual changes jobs, they will need to be more aware of their contribution limits as one employer will not know what amount was contributed while working for another.

If annual contributions are over IRS limits for a year, it’s the individual’s responsibility to notify their plan administrator so the excess amount can be returned to them before April 15th of the next year. If this doesn’t happen, the additional contribution amount doesn’t reduce their taxable income, and they must pay tax on it when they withdraw it. This essentially taxes the same income twice. Having contributions over the IRS limits remain in the self-directed 401(k) account can also result in the IRS disqualifying your plan.

Disqualified Investments

It’s important for individuals not to take the “self-directed” portion of their 401(k) plan to extremes. If a self-directed 401(k) plan is through an employer, they can still put restrictions on the kind of investments they make. For example, some employers may limit individuals to mutual funds.

The IRS also warns individuals with self-directed 401(k) plans to be aware of “fraudulent schemes, high fees, and volatile performance.” They also need to be careful not to accidentally violate IRS rules for self-directed plans, which can be very complicated. These rules explicitly ban things like:

  • An individual directly receiving money from an income-producing property in the self-directed 401(k)
  • Individuals using real estate that is held in the self-directed 401(k) account as collateral for personal loans.
  • Individuals using other investments or properties in the account in a way that benefits them personally
  • Individuals borrowing money from the 401(k) account to lend to a disqualified person or repay a personal loan obligation
  • Individuals allowing disqualified persons to live on a property that is owned within the self-directed 401(k)
  • Individuals leasing or selling property that is in the self-directed 401(k) account to disqualified persons

Transactions Between Related Parties

It’s also best not to entangle a self-directed 401(k) plan for family members. Family in this purpose is defined as children, grandchildren, parents, grandparents, spouse, and children and grandchildren of one’s spouse.

This means individuals can’t lend money from their self-directed 401(k) plan to relatives, invest in businesses that relatives own, allow relatives to live on property owned by the self-directed 401(k) plan, or otherwise have their relatives benefit from their 401(k) plan.

Distributions

Self-directed 401(k) plans have the same rules and regulations regarding distributions as traditional plans do. If an individual withdraws money from a self-directed 401(k) before they are 59 1/2 years old, they are subject to a 10% early withdrawal penalty unless they qualify for an exemption.

Some plans allow for hardship withdrawals for individuals having serious and immediate financial needs. It’s possible to qualify for a hardship withdrawal and not qualify for the exemption, meaning they’ll need to pay the 10% penalty for taking money out early.

Rollovers

Individuals can also rollover money from a self-directed 401(k) plan to another self-directed 401(k) plan, IRA, or qualified retirement plan just as they can with traditional 401(k) plans. They will have 60 days from the time they remove the money from their self-directed 401(k) plan to roll that money into another plan before it becomes a taxable withdrawal.

The brokerage hosting a self-directed 401(k) plan can assist individuals in making a direct, tax and penalty-free rollover.

Setting Up a Self-Directed 401(k)

Individuals need to have earned taxable income in the current financial year to be eligible to open a self-directed 401(k) plan. Some employers offer self-directed 401(k) plans in place of traditional plans. In this case, the plan administrator would also manage the self-directed 401(k).

There are three basic ways individuals can fund their self-directed 401(k):

  • Contributions: deferring income into the 401(k) account
  • Rollovers: rolling over funds from previous traditional IRAs and 401(k)s, SIMPLE IRAs, SEP-IRAs, and self-directed 401(k)s
  • Profit-Sharing: receiving a direct share, can be up to 25%, of the sponsoring business’s profits

Self-directed 401(k) accounts are ideal for individuals who have a solid understanding of IRS rules and investing strategies and have the time required to manage them. Download Jeff William’s free Profit Prism Small Account Starter Pack and learn how to grow your account today.

Author: Ben Sturgill

Ben leads two services at RagingBull. IPO Payday can help you pinpoint, position, and profit from IPOs. In Daily Profit Machine Ben guides day and swing traders to profit by trading the SPY Index. Ben hosts the RagingBull.com weekly podcast WealthWise where he shares thoughts on wealth and success with traders, businesspeople, entrepreneurs, and experts to uncover and share the wisdom needed to live a wealthy life.

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