Most employers offer a simple pathway to invest for the future via the traditional 401(k), but the truth is that your average 401(k) can be pretty rigid in terms of investment options, so it’s worth exploring the benefits of setting up a self-directed 401(k).

This complete guide explains what a self-directed 401(k) plan is, the pros and cons of self-directing your 401(k), and how to set one up.

Key Takeaways

• A self-directed 401(k) is a retirement account that lets you invest in a wider range of asset classes to diversify your portfolio and “future-proof” your retirement fund.

  
  

• Self-directed 401(k) plans generally require more time and market knowledge to make sure your portfolio is balanced and optimized.

  
  

• Self-Directed 401(k) rollovers and withdrawals are subject to the same rules as traditional 401(k) plans.

What is a Self-Directed 401(k)?

A self-directed 401(k) is a retirement account that gives you the flexibility to invest your income in a wider range of assets than a traditional 401(k) enabling you to have more control over your retirement.

With a traditional 401(k), your employer will often give you a limited choice of investment vehicles to grow your nest egg for the future. These options are usually limited to slow-growth mutual funds and index funds.

A self-directed 401(k) gives you more freedom with your investments by enabling you to invest portions (or all) of your monthly contributions in the funds or asset classes of your choice.

Jon Morgan, CEO of consultancy firm Venture Smarter, explains:

“With a self-directed 401(k), participants can invest in a broader range of assets beyond the typical options offered in regular 401(k) plans, such as stocks, bonds, and mutual funds” 

“They can also invest in alternative assets like real estate, private equity, precious metals, and even cryptocurrencies.”

Other, less conventional investment vehicles you can invest in using a self-directed 401(k) include:

• Tax liens

• Private placements

• Energy investments

• Equipment leasing

• Foreign currency

Despite the freedoms offered by self-directing your 401(k), it’s important to note there are a couple of limitations surrounding potential retirement investments. 

For example, you can’t use a self-directed 401(k) to hold artwork, antiques, or insurance policies.

But generally speaking, a self-directed 401(k) is an option worth exploring for individuals who are keen to gain better control over their investments for retirement.

Why Would You Set Up a Self-Directed 401(k)?

With a self-directed retirement plan, you get a wider range of options in terms of asset classes and more flexibility to invest different amounts of cash in different places, which may be the key to combating inflation.

According to ​​Spencer Hilligoss, CEO of Madison Investing, this flexibility empowers individuals to diversify their portfolios and future-proof their retirement funds. He states:

“In today’s economic climate, the recession resiliency of an investor’s portfolio is more important than ever. The ability to spread retirement funds outside of the stock market and into alternative assets such as real estate, precious metals, and more provides effective downside protection from inflation”

“Traditional investment vehicles such as stocks, often lack an adequate hedge against inflation, given their greater correlation with market performance vs. inflation rates.”

Utilizing a self-directed 401(k) can help you protect your nest egg from external forces, while also providing the same benefits that you could expect with a traditional 401(k) plan.

Both self-directed and traditional 401(k) plans offer pre-tax savings thanks to automatic payroll deductions, and both have rules when it comes to contribution limits, withdrawals, and rollovers.

If your employer offers a self-directed 401(k) plan as part of its wider range of retirement contribution options, you’ll probably be looking at the same annual contribution limits you’d expect to see with traditional 401(k).

But if you’re self-employed or take on a 401(k) plan outside of your employer’s offerings, the IRS will class that plan as a solo 401(k), which means you’ll benefit from higher contribution limits.

In 2023, the IRS limit for aggregate contributions to a solo 401(k) was $66,000 for those under 50 years old and $73,500 for those over 50. That’s almost three times the IRS contribution limit for traditional IRAs.

That means you can invest more aggressively when you self-direct a solo 401(k). By doing so, you should hopefully be able to generate bigger returns in a shorter amount of time, although it’s important to remember that with investments comes a bit of risk.

What Are the Risks of Setting Up a Self-Directed 401(k)?

One of the key risks of a self-directed 401 (k) is that you’re not going to get as much support from plan administrators.

Michael Hammelburger, CEO of the Bottom Line Group, a cost segregation firm based in Baltimore states:

“The possibility of making poor investment decisions or falling victim to fraudulent schemes is a significant risk. The account owner is solely responsible for conducting thorough due diligence and adhering to IRS regulations.”

“Furthermore, certain investments may be more risky and illiquid, making it critical to assess risk tolerance and maintain a well-balanced portfolio.”

In addition to risk, self-directed 401(k) plans also tend to generate higher maintenance and transaction fees. 

This is because when you’re in charge of your own portfolio, you’ll end up trading more often and each trade needs to be done through a broker and costs money; therefore, your trading fees could end up eating into your returns.

Self-directed 401(k) plans are also more high-maintenance. 

Unless you’re investing cash in an index fund or a professionally managed mutual fund, you’ll need to check in on your portfolio more frequently to see how it’s performing and make necessary adjustments. That takes time and some market knowledge that some people simply don’t have.

How Do You Set Up a Self-Directed 401(k)?

If you’re comfortable with the risks of setting up a self-directed 401(k), the process of self-directing your 401(k) is pretty simple as they are available through most banks and financial institutions.

To get started, you need to be generating taxable income either on a self-employed basis or through an employer. Some employers offer a self-directed 401(k) alongside the more traditional plans, which will be managed by the same plan administrator.

If your employer doesn’t offer a self-directed option or you’re self-employed, you’ll need to find your own plan administrator or custodian to handle your plan’s administrative aspects.

Venture Smarter’s Jon Morgan explains:

“The process of setting up a self-directed 401(k) typically involves completing the necessary paperwork and complying with IRS regulations and reporting requirements.”

“Once the account is set up, you'll need to fund it by making contributions, either through employer contributions, employee salary deferrals, or both”.

Unfortunately, keeping up with all the right documentation and making sure it’s accessible by the right parties takes a lot of organization. That’s where a Family Operating System® like Trustworthy can offer vital support.

Trustworthy is a digital ecosystem that gives you a bird’s eye view of all of your essential family documents via one, intuitive dashboard. With Trustworthy, you can upload and create digital copies of all your financial information, insurance policies, identification, investment documentation, and everything in between.

You’re then able to share those essential documents with your financial planner or accountant securely to ensure you’re abiding by all the necessary IRS regulations.

Want to learn more? Explore the benefits of Trustworthy now.

What Are the Rules on Self-Directed 401(k) Rollovers and Withdrawals?

“Self-Directed 401(k) rollovers and withdrawals are subject to the same rules as traditional 401(k) plans,” says the Bottom Line Group’s Michael Hammelburger.

“When changing jobs or consolidating retirement accounts, rollovers allow funds to be transferred without incurring taxes or penalties. However, unless an exception applies, early withdrawals before the age of 59-and-a-half may be subject to income tax and a 10% early withdrawal penalty” he explains.

To make informed decisions about rollovers and withdrawals from a Self-Directed 401(k), you must stay up-to-date on all the relevant IRS guidelines. I also recommend you consult with a financial planner, accountant, or tax advisor.

It’s also worth noting that the IRS does prohibit some types of transactions when you’re using a self-directed 401(k). Prohibited transactions involve using your plan to benefit a disqualified person like a family member or plan fiduciary (which is somebody who services the plan).

Examples include:

• Selling, exchanging, or leasing property to a disqualified person

• Lending money from your plan to a disqualified person

• Extending credit to a disqualified person

• Buying goods, services, or facilities for a disqualified person

If you use a self-directed 401(k) to make a prohibited transaction, you’ll lose the tax advantages of your account investments, resulting in a big tax bill.

Frequently Asked Questions

What is the Difference Between a 401(k) and a Self-Directed 401(k)?

A self-directed 401(k) lets you choose how to invest your pre-tax retirement contributions. A traditional 401(k) plan limits your investment options to a choice of pre-approved funds.

What is the Difference Between a Self-Directed IRA and a Self-Directed 401(k)?

The key difference between a self-directed 401(k) and a self-directed IRA is that an employer will generally sponsor a 401(k) plan. You’re responsible for establishing and maintaining your own account when using an IRA.

How Much Can You Put Into a Self-Directed 401(k)?

The IRS contribution limit for employer-sponsored self-directed 401(k) plans is $22,500 in 2023 if you’re under 50 or $30,000 if you’re over 50. If you’re self-employed, the IRS limit is $66,000 if you’re under 50 years old and $73,500 if you’re over 50.