Self-Directed 401(k)

Written by True Tamplin, BSc, CEPF® | Reviewed by Editorial Team

Updated on December 13, 2022

What Is a Self-Directed 401(k)?

A self-directed 401(k) is an employer-sponsored retirement savings plan that allows employees more freedom in their investment choices. It has many similarities with standard 401(k) plans but comes with more investment alternatives and additional guidelines. 

Regular 401(k) plans typically offer mutual funds, bonds, and stocks as investment choices. Meanwhile, self-directed 401(k)s allow employees to invest in more unorthodox items like real estate, precious metals, foreign currency, tax liens, equipment leasing, and private placements.

Employees who choose to have a self-directed 401(k) can personally make the buying and selling decisions for their accounts. However, the transactions will be executed for the employee by their administrator, who is a qualified custodian from an investment firm or a brokerage.

Self-directed 401(k)s offer both a traditional (pre-tax) and Roth (after-tax) option. This article will focus on the pre-tax, traditional version of the self-directed 401(k). 

Self-Directed 401(k) Contribution Limits

Self-directed 401(k) plans have the same contribution limits as standard 401(k) plans. 

Both plans have an employee contribution limit of $20,500 in 2022, which has increased to $22,500 in 2023. Older employees aged 50 and above are entitled to make catch-up contributions of up to $6,500 in 2022 or $7,500 in 2023. 

Aside from this, employers can contribute more to their employee’s retirement plan, provided it does not exceed the total contribution limit when added to the employee’s contributions. 

The total contribution limit for the self-directed 401(k) and the standard 401(k) in 2022 is $61,000 or $67,500 for those 50 and older. This has increased in 2023 to $66,000 or $73,500, respectively. 

Self-Directed 401(k) Rollovers and Withdrawals

The withdrawal and rollover rules for self-directed 401(k) plans are the same as those for standard 401(k) plans. Both these plans were funded with pre-tax dollars. This means that contributions will grow on a tax-deferred basis, but most withdrawals are expected to be taxed. 

According to the Internal Revenue Service (IRS) guidelines, if an employee makes a withdrawal before the age of 59½, they will have to pay a 10% penalty on top of the deferred taxes. There are some exceptions to this rule, such as when an employee needs to take a hardship distribution.

Employees also have 60 days to roll over a self-directed 401(k) plan to an Individual Retirement Arrangement (IRA) before the money withdrawn becomes tagged as a taxable withdrawal. 

With all of these rules to consider, individuals may seek advice from their custodian if they hope to process a tax and penalty-free rollover.

Prohibited Transaction Rules in a Self-Directed 401(k)

Despite the relative freedom that a self-directed 401(k) brings, individuals still have to be careful not to engage in prohibited transactions, or they will lose their account's tax privileges. 

The following are some of the transactions that are considered prohibited by the IRS:

  • A sale, lease, transfer, payment, or exchange between a self-directed 401(k) owner and a disqualified person
  • Utilizing investments in the account, such as real estate or property, in a way that would benefit disqualified persons

Disqualified persons are individuals or groups who provide services or have a financial interest in the plan. This includes family members and account beneficiaries such as spouses, parents, grandparents, children, and grandchildren,

It also includes the plan owner and anyone else who would financially benefit from the plan's success, such as the plan's custodian, administrator, or any company over which the plan owner has voting rights. 

If found to have participated in prohibited activities, the retirement plan will no longer enjoy tax benefits. Instead, all investments will be taxed immediately. In addition, disqualified persons who engaged in these activities will also be asked to pay a separate tax

Benefits of Self-Directed 401(k)

Self-directed 401(k)s are appealing to some individuals for the following reasons:

  • Pre-Tax Savings: By contributing to a self-directed 401(k), individuals can reduce the amount of taxable income reflected in their IRS Form 1040, thus reducing the total amount of money that would typically be owed in taxes.
  • Increased Control Over Investments: With a self-directed 401(k), investments are not restricted to what the plan administrator picks, but the contributor gets to choose where to invest instead.
  • More Investment Choices: There is a broader array of investment choices available. With a self-directed 401(k), the contributor can invest in anything from stocks and bonds to real estate and tax liens.

 

Drawbacks of Self-Directed 401(k)

Like any retirement program, self-directed 401(k)s also have their drawbacks, which include:

  • Higher Fees: With a self-directed 401(k), individuals might pay higher total fees if they choose to invest in assets that come with additional charges. For example, stocks that are traded regularly also come with added costs.
  • Time and Expertise Required: A self-directed 401(k) requires significant expertise and time investment to manage correctly. Even experienced investors would need to allot ample time studying the market to make sound investment decisions.
  • Complicated Transaction Rules: Self-directed 401(k)s give employees more freedom of choice. However, they must vigilantly abide by the rules and ensure they do not engage in prohibited transactions.

Pros_&_Cons_of_Self-Directed_401(k)s

How to Set up a Self-Directed 401(k)

Individuals who wish to set up a self-directed 401(k) account may follow these steps: 

  • Earn Taxable Compensation: To be eligible to start a self-directed 401(k), an employee must meet one criterion. They must have earned taxable compensation during the current fiscal year.
  • Check Your Employer’s Offers: Self-directed 401(ks) may not be available in some companies. Thus, it is a good idea to check with your employer to confirm if they offer a self-directed 401(k) option.
  • Fund Your Account: Aside from employee contributions, self-directed 401(k)s may be funded through transfers from other retirement plans except for Roth IRAs. They may also be financed by employer contributions or profit-sharing. 

How_to_Set_up_a_Self-Directed_401(k)

Final Thoughts

A self-directed 401(k) is an employer-sponsored retirement savings plan that allows employees more freedom in their investment choices. 

In addition to the mutual funds, bonds, and stocks offered by standard 401(k)s, self-directed 401(k)s allow employees to invest in more unorthodox items like real estate, precious metals, foreign currency, tax liens, equipment leasing, and private placements.

Employees who choose to have a self-directed 401(k) can personally make the buying and selling decisions for their accounts. However, the transactions will be executed for the employee by their administrator, who is a qualified custodian from an investment firm or a brokerage.

Self-directed 401(k)s have many similarities with standard 401(k) plans, including contribution limits, withdrawal rules, and rollover processes. However, it comes with more investment alternatives and additional guidelines on prohibited transactions. 

This type of plan has its benefits and drawbacks. Some advantages are enjoying pre-tax savings, having more control over investment decisions, and getting broader investment choices.

The disadvantages include paying more fees, complicated transaction rules, and needing to allot more time and gain more expertise. 

If you are undecided about whether or not to avail of the self-directed 401(k) option, you may consult with a financial advisor who can guide you through your decision-making process.

FAQs

What is a self-directed 401(k)?

A self-directed 401(k) is an employer-sponsored retirement savings plan that allows employees more freedom in their investment choices. It has many similarities with a standard 401(k) plan, including contribution limits, withdrawal rules, and rollover processes. However, it comes with additional guidelines on prohibited transactions.

What are your investment options if you have a self-directed 401(k)?

Aside from mutual funds, bonds, and stocks, self-directed 401(k)s allow employees to invest in unorthodox assets like real estate, precious metals, foreign currency, tax liens, equipment leasing, and private placements.

Is a self-directed 401(k) the same as a solo 401(k)?

A self-directed 401(k) is an employer-sponsored retirement savings plan that allows employees more freedom in their investment choices. In contrast, the solo 401(k) is a retirement plan designed for an individual business owner who does not have any employees.

How much can you put in a self-directed 401(k)?

Self-directed 401(k)s have an employee contribution limit of $20,500 in 2022, which has increased to $22,500 in 2023. Older employees aged 50 and above are entitled to make catch-up contributions of up to $6,500 in 2022 or $7,500 in 2023.

How do you contribute to a self-directed 401(k)?

Aside from employee contributions made through salary deductions, self-directed 401(k)s may be funded through transfers from other retirement plans except for Roth IRAs. They may also be financed by employer contributions, which are done through their matching or profit-sharing.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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