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 2024 tax year, you can defer the lesser of 100% of your annual earnings or $23,000. Catch-up provisions allow those over the age of 50 to contribute an additional $7,500 per year.
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.
Article By
The Human Interest TeamWe believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.
