Self-directed 401(k) accounts aren’t as common as managed or target-date 401(k) plans, but they can be of real value for DIY-minded investors.
What is a self-directed 401(k)? These 401(k) plans — which may be employer-sponsored or available as a solo 401(k) for self-employed individuals — expand account holders’ investment choices, giving them more control over their own retirement plans. Instead of being limited to a packaged fund, an investor can choose specific stocks, bonds, mutual funds, and sometimes even alternative investments, in which to invest their retirement money.
What Is a Self-Directed 401(k) Account?
The key promise of self-directed 401(k) plans is control. They allow retirement plan savers to basically act as a trustee for their own retirement funds.
A self-directed 401(k) plan offers expanded investment choices, from stocks, bonds, funds, and cash, to alternative investments like Real Estate Investment Trusts (REITs) and commodities.
For a plan holder who believes they have the investment know-how to leverage better returns than a managed fund or target-date fund, a self-directed 401(k) can be an appealing choice.
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Who Is Eligible for a Self-Directed 401(k)?
As long as your employer offers a self-directed 401(k), and you have earned taxable income for the current calendar year, you can enroll.
Alternatively, if you are self-employed and own and run a small business alone, with no employees (aside from a spouse), and your business earns an income, you are also eligible. You can search for a financial institution that offers self-directed plans, which might include a solo 401(k).
This is one of the self-employed retirement options you may want to consider.
How to Set Up a Self-Directed 401(k)
Setting up a self-managed 401(k) plan can be fairly straightforward. Once a 401(k) account is established, employees can fund it in the following ways:
• Plan transfer. An employee can shift funds from previous or existing 401(k) plans and individual retirement accounts (IRAs). However, Roth IRAs can’t be transferred.
• Profit sharing. An employee receiving funds from a company through profit sharing can use that money to open a self-directed 401(k) plan — up to 25% of the profit share amount.
• Direct plan contributions. Any income related to employment can be contributed to a self-directed 401(k) plan.
Recommended: How to Manage Your 401(k)
Pros and Cons of Self-Directed 401(k)s
Like most investment vehicles, self-managed 401(k) plans have their upsides and downsides.
Pros of Self-Directed 401(k) Plans
These attributes are at the top of the self-directed 401(k) plan “advantages” list:
• More options. Self-directed 401(k) plans allow retirement savers to gain more control, flexibility, and expanded investment choices compared to traditional 40k plans, putting their money exactly where they want — without relying on established funds.
• Tax deferral. Like regular 401(k) plans, all self-directed 401(k) plan contributions and asset gains are tax-deferred.
• Employee matching. Self-directed 401(k) plans make room for employer matching plan contributions, thus potentially paving the way for more robust retirement plan growth.
• Plan diversity. Account holders can invest in assets not typically offered to 401(k) plan investors. Alternative investments like real estate, gold, silver and other commodities, and private companies are allowed, thus lending additional potential for diversity to self-directed 401(k) plans.
Cons of Self-Directed 401(k) Plans
These caveats and concerns are most often associated with self-directed 401(k) plans:
• Higher-risk investments. Historically, alternative investments like precious metals and real estate come with more volatility — and hence more risk — than stocks and bonds.
• Diversification is on you. You’ll need to choose among stocks, bonds and funds to augment your self-directed 401(k) plan asset allocation.
• Higher fees. Typically, self-directed employer retirement plans cost employees more to manage, especially if an investor makes frequent trades.
• Larger time investment. Since self-directed 401(k) plans offer access to more investment platforms, savers will likely need to spend more time doing their due diligence to research, select, and manage (especially in the area of risk assessment) their plan options.
💡 Quick Tip: Want to lower your taxable income? Start saving for retirement with a traditional IRA. The money you save each year is tax deductible (and you don’t owe any taxes until you withdraw the funds, usually in retirement).
How Much Money Can be Put in a Self-Directed IRA?
The amount an investor can contribute to a self-directed IRA is the same as the amount that can be contributed to a traditional IRA. For 2023, the limit is $6,500. Those aged 50 and older can also make an additional catch-up contribution of $1,000 in 2023.
For a self-directed 401(k), the amount that can be contributed is the same as the contribution limits for a traditional 401(k). For 2023, the limit is $22,500. For those age 50 and older, there is the option of making an additional catch-up contribution of up to $7,500. That means an individual 50 or older could contribute as much as $30,000 to a self-directed 401(k) in 2023.
Recommended: IRA vs 401(k)
Common Self-Directed 401(k) Investments
The ability to choose from an expanded list of investment categories is an intriguing benefit for a 401(k) plan holder who believes they have the investment know-how to leverage better returns from investments like self-directed 401(k) real estate, precious metals, or shares of private companies, among other eligible alternative investments.
For any retirement saver looking to leverage those options, the key is understanding what potential opportunities and what risks those extra self-directed investment vehicles bring to the table. Here’s a closer look at two of the more common alternative investments linked to self-directed 401(k) plans.
Real Estate Investment Trusts (REITs)
Investing in real estate simply means investing in residential or commercial properties, or real estate funds, with the goal of income generation. A self-directed 401(k) plan allows for real estate investing outside of the plan holder’s personal residence.
Examples of residential properties include:
• Single-family homes
Examples of commercial real estate include:
• Multi family homes
• Office or retail buildings
• Storage facilities and warehouses
To invest in real estate with a self-directed 401(k) plan, an investor would use their 401(k) funds to purchase the property, as well as to pay for maintenance, taxes, and other property-related expenses.
Real estate can be cyclical in nature, and can require large amounts of cash when investing in direct real estate properties. Thus, risk of investment loss is real and must be treated prudently by self-directed 401(k) real estate investors.
Investing in “hard commodities” like gold, silver, titanium, copper, zinc, and bronze, among other metals, are allowable with self-directed 401(k) plans. Self-directed 401(k) plan participants can either invest in precious metals directly, like buying gold bullion or coins, or invest in precious metals via stocks or precious metal funds.
Precious metal investing can be high risk, as gold, silver, and other metals can be highly volatile in value. As with real estate, investors have to be able to ride out chaotic market periods for commodities — but for some, the potential payoff may be worth it.
Investments That Aren’t Allowed Under Self-Directed 401(k) Plan Rules
While the list of investment vehicles that are included in a self-directed 401(k) plan are substantial, regulatory rules do prohibit specific investment activities tied to several of those asset classes. The following investment strategies and associated transactions, for example, would not pass muster in self-directed 401(k) plans.
Real Estate with Family Ties
While investing in real estate is allowed in a self-directed 401(k) plan, using that real estate for extended personal gain is not allowed. For example, that could include buying an apartment and allowing a family member to live there, or purchasing a slice of a family business and holding it as a 401(k) plan asset. Neither of these scenarios is allowed under 401(k) plan regulatory rules.
Self-directed 401(k) plan consumers may not loan any plan money to family members or sign any loan guarantees on funds used in a self-directed 401(k) plan.
No Investment Benefit Beyond Asset Returns
Self-directed 401(k) plan holders cannot earn “extra” funds through transactions linked to plan assets. For example, a plan holder can buy a real estate property under 401(k) plan rules but he or she cannot charge any management fees nor receive any commissions from the sale of that property.
Basically, a self-directed 401(k) plan participant cannot invest in any asset category that leads to that plan participant garnering a financial benefit that goes beyond the investment appreciation of that asset. That means not using 401(k) funds to purchase a personal residence or investing in assets like investments of collectibles (i.e. vehicles, paintings or jewelry or real estate properties that the plan participant personally uses.
Manage Your Retirement Savings With SoFi
While self-directed 401(k) plans can add value to a retirement fund, self-directed retirement planning is not for everyone.
This type of account requires more hands-on involvement from the plan holder than a typical target-date or managed fund might. Additionally, investing in alternative investments like precious metals, real estate, and other risk-laden investment vehicles, require a realistic outlook on downside risk and a healthy knowledge of how investments work beyond stocks, bonds, and funds.
In the meantime, you might want to consider rolling over any old 401(k) accounts to a rollover IRA to better manage your retirement savings overall.
Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
What is the difference between an individual 401(k) and a self-directed 401(k)?
A self-directed 401(k) gives account holders more investment choices, as well as more control over their own retirement plans. Instead of being limited to a packaged fund as they would be with an individual 401(k), an investor can choose specific stocks, bonds, mutual funds, and even alternative investments, in which to invest their retirement money.
Can I roll my traditional 401(k) into a self-directed 401(k)?
Yes. You can shift funds from a previous or existing 401(k) plan or individual retirement account (IRA) into a self-directed 401(k). The exception is a Roth IRA, which can’t be transferred.
How is a self-directed 401(k) taxed?
Like regular 401(k) plans, all self-directed 401(k) plan contributions and asset gains are tax-deferred until withdrawn. With self-directed 401(k)’s, there is a 10% tax penalty for early withdrawals (before age 59 ½), the same as with traditional 401(k)s.
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