All About Self-Directed 401(k)s

A 401(k) plan is a valuable tool for saving for retirement. However, most 401(k) plans offer limited options in which to invest and only narrow timeframes for making changes. Self-directed 401(k) plans give the benefits of a traditional 401(k) with more control over how your money is invested.

What Is a self-directed 401(k)?

A self-directed 401(k) is a retirement plan approved by the Internal Revenue Service under the 1981 rules, the same as a traditional 401(k). Employees can make pre-tax contributions through payroll deduction. 

If you are someone who prefers more control over their retirement funds and more flexibility, a self-directed 401(k) plan may be a good option for you because it gives you more flexibility. With a self-directed 401(k) plan, your employer has the option of letting you invest all or some of your money in funds of your choosing during a designated brokerage window. Each employer can choose whether or not to offer a brokerage window, and from which types of investments you can select.

With a self-directed 401(k), you can invest in what you want as long as it’s legal. Real estate, land,  and precious metals are just a few possibilities. You are not as restricted as you are with traditional retirement accounts through a brokerage.

What is a traditional 401(k)?

A traditional 401(k) lets an employer match all or some of the contributions made by eligible employees. Employers may choose from a few different types of traditional 401(k) plans.

• Safe Harbor 401(k) plans are unique in that the contributions are fully vested and can be made by the employer even if employees don’t make their own contributions.

• Tiered Profit Sharing 401(k) plans are an excellent choice for businesses with 50 or fewer employees who regularly turn a significant profit. These plans let the employer make contributions based on profit sharing.

• Simple 401(k) plans are for business with 100 or fewer employees who earn at least $5,000 each. These plans allow for fully vested contributions by employees and employers.

Who can benefit from a self-directed 401(k)?

Self-employed people, contractors, and owners of a sole proprietorship may find a self-directed 401(k) beneficial. Spouses can be members of the plan so that you don’t need a custodian as you do with an Individual Retirement Account (IRA). You must meet specific criteria and follow certain rules to qualify to open a self-directed 401(k) plan.

• To open a self-directed 401(k) plan for yourself as a business owner, you must be a sole proprietor with no employees other than your spouse. The partners in a partnership, along with their spouses, can also qualify if there are no other employees.

• You must have taxable compensation as an individual during the current financial year.

• The deadline for setting up a self-directed 401(k) plan, regardless of the company’s corporate structure, is the last day of the tax year.

• The self-directed 401(k) should be the only one maintained by the business unless otherwise dictated by law.

Who is disqualified from investing in the self-directed 401(k)?

The Internal Revenue Service (IRS) Code 4975(e)(2) lists the conditions under which someone is disqualified from participating in a self-directed 401(k). 

• A person who is providing services to the 401(k) plan cannot make contributions to it.

• A person who has the authority to make investment decisions for the 401(k) plan cannot contribute to it.

• Parents, grandparents, children, and grandchildren of either of the above may not contribute.

What investments are prohibited for a self-directed 401(k)?

Under IRS regulations, a self-directed 401(k) cannot make certain types of investments.

• The 401(k) plan cannot engage in any transaction with a disqualified person. For example, a plan participant can’t use those funds to buy part of a business that belongs to the participant’s parent.

• The 401(k) plan cannot receive any benefits from the plan, either directly or indirectly. For example, a plan participant can’t buy a rental property with those funds and then charge a management fee.

• The self-directed 401(k) plan cannot invest in collectibles such as art or cars.

What are the advantages of a self-directed 401(k)?

Self-directed 401(k) plans offer some benefits for you as the employee and for your employer.

• For the 2025 tax year, you can defer the lesser of 100% of your annual earnings or $23,500. Catch-up provisions allow those over the age of 50 to contribute an additional $7,500 per year, with an increased amount of $11,250 for those aged 60-63.

• Contributions to a self-directed 401(k) plus the earnings are tax-deferred until you withdraw them. 

• You can choose to have your contributions deducted from your pay and set the amount.

• Your employer can also make contributions on your behalf.

• You have control over your investments since you can choose where to put the money within the options the plan offers.

• Self-directed 401(k) plans are portable so you can roll the funds over if you move to a different job.

What are the disadvantages of a self-directed 401(k)?

Self-directed 401(k) plans have a few disadvantages.

• These plans are expensive for employers to set up and monitor. The administrative costs of managing loans, early withdrawals, and other transactions require a great deal of costly oversight.

• Since the employer chooses your investment options, you may not get a wide variety of choices, and you may be dissatisfied with the quality. If you don’t have a range of index funds available, long-term management can be challenging.

• The employer also sets the eligibility rules, so those who are part-time, new, or union members may be excluded, for example.

• If you make a withdrawal from the plan before you are age 59 1/2, you may incur a 10% penalty, unless you retire in the calendar year you turn 55.

What are the rules on self-directed 401(k) rollovers and withdrawals?

The rules governing withdrawals and rollovers are the same for a self-directed 401(k) and a traditional one or an IRA. 

How does a self-directed 401(k) loan work?

A self-directed 401(k) plan allows you to take out a low-interest, personal loan against the plan. You can borrow up to 50% of the value of the account or $50,000, whichever is less.