What is a Self-Directed 401(k)?

Interested in a self-directed 401(k) to boost the returns in your retirement portfolio? Keep reading to find out all you need to know. 

It’s a sad truth, but for most of us, the era of people working for the same company for 25 years and then retiring with a gold watch and a pension are gone. It was once commonplace, but these days, only public employees and union members with solid contracts will retire with pensions. 

For most of the private sector, employee pensions have been replaced with 401(k) funds. In 401(k) funds, employees can designate a certain amount of their salary deducted on a tax-deferred basis and then contribute that money to the fund. Some employers match a small percentage of the workers’ contribution and then, theoretically, the fund grows the wealth through investments made by the fund administrator. In a perfect world, when the employee retires, they can begin withdrawing from the fund to support themselves.

What is a Self-Directed 401(k)?

In a traditional 401(k), the employer who offers them will hire a fund manager or investment firm to manage the fund and make all the investment decisions. The firm, or the fund manager, is usually an experienced financial professional or team of experts who diversify the fund across a number of different traditional investment offerings. 

Although most 401(k)s use a slow growth model, some 401(k)s even offer workers a choice of how they would like their money invested. They may offer workers a choice between an aggressive style that concentrates mainly on high-yield offerings (with higher risk) and a traditional conservative style that grows money more steadily through more established offerings. Various target date funds that choose investments based on the plan members’ projected retirement dates may also be offered.

However, some workers want even more control than that and, if their company offers it, opt for a self-directed 401(k). In a self-directed 401(k), the employee makes pre-tax contributions and grows wealth, but the employee decides where to invest the contributions as opposed to the fund manager. Along with self-directed individual retirement accounts (IRAs), the self-directed 401(k) offers workers the highest level of control over their financial futures when it comes to tax-deferred investments.

Other Differences Between Self-Directed and Employer-Run 401(k) Programs

In most traditional 401(k) programs, the fund focuses on traditional investments, although few may participate in alternative investments like real estate. But generally, even the aggressive funds adopt more of a slow-growth strategy that models the behavior of several stock indexes. Apart from choosing the investment style, employees with traditional 401(k)s are passengers. They make the contributions, and the fund manager invests them.

The independence offered by a self-directed 401(k) program allows investors to choose from a much wider range of investment offerings. Examples of the kinds of investments you can make with a self-directed 401(k) include:

• Foreign currency
• Real estate (real estate investment trusts, real estate limited partnerships)
• Property tax liens
• Private placement offerings
• Precious metals

Your self-directed 401(k) can diversify itself across all of these types of offerings or put all of its eggs in one particular basket. With a self-directed 401(k), you are in almost full control of the boat. However, there are some limits. Self-directed 401(k) funds are prohibited from participating in some alternative offerings such as fine art, sports, collectibles, wine and insurance products. 

Pros of Self-Directed 401(k) Funds

The most obvious advantages of self-directed 401(k) funds are the investor control and the flexibility they offer. For example, if you had a self-directed 401(k) last year when the AMC movie chain meme stock exploded in value, you could’ve jumped on that train and bought shares.

By contrast, a traditional 401(k) fund manager usually has a set plan for how they’re going to grow wealth and is usually restricted to 10 or fewer mutual funds or exchange-traded funds for investing. Few 401(k) plans invest in individual stocks. That means that 401(k) managers may have blinders on or brakes locked when it comes to hot individual investments. They wouldn’t or couldn’t buy a stock on your recommendation. 

401(k) fund managers are limited to the plans offered in the company’s retirement fund and must invest the investment capital of the collective fund membership within those limits. 

With a self-directed 401(k), you have the flexibility to grow wealth or invest as you see fit. You’re free to put your contributions into whatever mix of traditional and alternative investments you choose (within limits). So, if your professional or personal experience gives you insight into a particular field of investment, you can concentrate your self-directed 401(k) contributions on that field.

For example, if you spent 10 years trading foreign currency or doing commercial real estate and you know what a good deal looks like, you can put all that knowledge to work growing your self-directed 401(k). A traditional 401(k) would not offer you that level of control. 

Cons of Self-Directed 401(k)s

The primary disadvantage of self-directed 401(k)s is that few employers offer them, and when they do, these plans tend to have much higher fees. Your self-directed plan will still have an administrator who will charge management and trading fees. Every transaction you make will have a fee associated with it. The more active you are with trading your self-directed 401(k), the more investor fees you’re going to pay, which reduces profits.

Also, if you get it wrong and make bad financial moves running your own 401(k), you’re the one who is going to suffer for it. The people who manage 401(k) funds are generally experienced financial professionals. They are trusted with the responsibility of running these plans because they’ve proven their ability to invest wisely and build wealth for many investors. Fund managers eat, sleep and breathe wealth building. You might make one hot investment, but to beat a fund manager growing wealth over the long haul requires a tremendous amount of expertise, attention and due diligence on your part. 

Prohibited Transactions in Self-Directed 401(k)s

Although self-directed 401(k)s give investors an elevated level of control over their financial futures, limits and restrictions exist. Much like a self-directed IRA, the 401(k) offers investors the chance to make tax-deferred contributions. That also means the IRS has a say in which transactions are permissible and which ones are not. If you conduct a prohibited transaction, you could lose the tax-deferment benefits of your self-directed 401(k).

The most common example of a prohibited transaction in a self-directed 401(k) is a one between the 401(k) owner and what is known as a disqualified person. Examples of disqualified persons include:

• The plan administrator or anyone who provides professional services to the plan (accountant or attorney who works for the plan owner)
• Companies that the 401(k) owner has more than a 50% equity share in
• Family members of the plan owner (parents, grandparents, children, in-laws)
• The plan owner because you can’t buy equity in your own LLC with self-directed 401(k) contributions

Although your plan administrator will clarify for you what transactions are prohibited, a good rule of thumb is that you can’t use self-directed 401(k) contributions for your immediate financial benefit. For example, if you have real estate assets in your self-directed 401(k) plan, you can’t use them to secure a personal loan. 

You would also be prohibited from leasing rental property in your 401(k) portfolio to family members or other disqualified persons. Remember, the whole point of the self-directed 401(k) is that you are not accessing this money until retirement, at which point it will be taxed. 

Contribution Limits

Both traditional and self-directed 401(k) programs have the same annual contribution limits. Workers under the age of 50 are allowed to contribute a maximum of $20,500 annually. Workers over 50 may contribute an additional $6,500, which creates a maximum annual contribution of $27,000.

Is a Self-Directed 401(k) Right For You?

The answer to this question will vary with every investor. Your financial acumen, ability to pay close attention to your 401(k), risk tolerance and investment goals are all factors that play into whether a self-directed 401(k) is right for you. For some people, the self-directed 401(k) offers skilled investors a way to take direct ownership of their financial future and grow their retirement income more rapidly. 

However, an inexperienced investor with a self-directed 401(k) can easily squander a significant chunk of their retirement income. Regardless of your experience level as an investor, it’s a good idea to consult with a financial advisor before taking part in a self-directed 401(k).