Self-directed 401k plans give investors the freedom to decide how their pre-tax retirement contributions are invested. Traditional 401(k) plans usually restrict you to pre-approved funds, but with self-directed 401k plans, you have the freedom to select your own investment options.
Here’s an in-depth look at Self Directed 401k to help you decide if it’s the best option for your retirement funds.
What is a Self Directed 401k?
A Self Directed 401k is a retirement plan that, as a traditional 401(k), is approved by the Internal Revenue Service under the 1981 regulations. Employees can contribute pre-tax through payroll deduction.
If you prefer more control over your retirement funds and more flexibility, a self-directed 401k plan may be a smart alternative for you because it provides more freedom. With a self-directed 401(k), your employer can allow you to invest all or part of your money in funds of your choice within a predetermined brokerage window.
Each company can decide whether or not to provide a brokerage window and which types of investments are available.
When you have a self-directed 401(k), you have the freedom to invest in legal options of your choice. You can explore opportunities in real estate, land, precious metals and more. Unlike traditional retirement accounts through a brokerage, there aren’t many restrictions with a self-directed 401(k).
Who can benefit from a Self Directed 401k?
Self-employed individuals, contractors, and sole proprietorship owners may benefit from a Self Directed 401k. Spouses can join the plan, avoiding the requirement for a custodian, as with an Individual Retirement Account (IRA). To open a self-directed 401(k) plan, you must meet a few criteria and follow certain rules.
- You must be a sole proprietor with no workers other than your spouse to start a self-directed 401(k) plan for yourself as a business owner. If there are no other employees, the partners of a partnership, along with their spouses, may also qualify.
- As an individual, you must have taxable compensation during the current fiscal year.
- Regardless of the company’s corporate structure, the deadline to set up a self-directed 401(k) plan is the end of the tax year.
- If not mandated by law, it is advisable for the company to maintain only the self-directed 401(k) plan.
Who is ineligible to invest in a Self Directed 401k?
The IRS Code 4975(e)(2) provides a list of conditions that can lead to disqualification from participating in a self-directed 401(k).
- If you are providing services to a 401(k) plan, you are not allowed to make contributions to it.
- Individuals who hold the power to make investment decisions for the 401(k) plan are prohibited from making contributions.
- Parents, grandparents, children, and grandchildren of any of the mentioned are not eligible to contribute.
Self Directed 401k Contribution Limited in 2023
Contribution limits for self-directed 401(k) plans are the same as for traditional 401(k) plans.
Employee contributions to both plans are limited to $20,500 in 2022, increasing to $22,500 in 2023. Employees over the age of 50 can make catch-up payments of up to $6,500 in 2022 or $7,500 in 2023.
Aside from that, companies can contribute more to their employees’ retirement plans as long as the overall contribution maximum is not exceeded when the employee’s contributions are included.
In 2022, the combined contribution limit for the self-directed 401(k) and normal 401(k) is $61,000, or $67,500 for those 50 and over. This has risen to $66,000 or $73,500 in 2023, respectively.
How to Set Up a Self Directed 401k?
If you are interested in a self-directed 401(k) account, you can use the following steps:
- Earn Taxable Compensation: In order to begin a self-directed 401(k), an employee must meet a single requirement: they must have received taxable compensation in the current fiscal year.
- Check Your Employer’s Offers: It’s possible that certain companies don’t provide self-directed 401(k)s. To make sure, it’s a good idea to verify with your employer whether they offer this option.
- Fund Your Account: In addition to employee contributions, self-directed 401(k)s can be funded through transfers from other retirement plans, with the exception of Roth IRAs. They can also be financed by employer contributions or profit-sharing.
Self Directed 401k Rollovers and Withdrawals
Self-directed 401(k) plans have the same withdrawal and rollover rules as traditional 401(k) plans.
Pre-tax funds were used to pay both of these plans. This means that contributions will grow tax-deferred, but most withdrawals will be taxed.
If an employee withdraws before the age of 59½, the Internal Revenue Service (IRS) requires them to pay a 10% penalty on top of the deferred taxes.
This regulation has occasional exceptions, such as when an employee needs to take a hardship distribution.
Employees also have 60 days to transfer funds from a self-directed 401(k) plan to an Individual Retirement Arrangement (IRA) before the money is considered taxable.
Considering all the rules, people may want to consult with their custodian to complete a tax and penalty-free rollover.
Prohibited Transaction Rules in a Self-Directed 401k
Despite the relative freedom that a self-directed 401(k) provides, individuals must be cautious not to engage in prohibited activities or risk losing their account’s tax advantages.
The IRS considers the following transactions to be prohibited:
- A sale, lease, transfer, payment, or exchange between a self-directed 401(k) owner and a disqualified individual
- Using account investments, such as real estate or property, to benefit unqualified individuals.
Individuals or groups who supply services or have a financial interest in the plan are disqualified.
This includes spouses, parents, grandparents, children, and grandkids, as well as account beneficiaries.
It also includes the plan owner and anybody else who stands to profit financially from the plan’s success, such as the custodian, administrator, or any corporation in which the plan owner has voting rights.
If unlawful actions are discovered, the retirement plan will no longer receive tax benefits. Rather, all investments will be taxed right away.
Disqualified individuals who engage in these activities will also be required to pay a supplementary tax.
Self Directed 401k: Pros & Cons
Self-directed 401(k) plans provide advantages for both employees and employers.
Pros:
- You can postpone the lesser of 100% of your annual earnings or $22,500 for the 2023 tax year. Catch-up provisions allow anyone over 50 to contribute an extra $7,500 per year.
- Contributions and earnings in a self-directed 401(k) are tax-deferred until withdrawn.
- You have the option of having your contributions debited from your pay and setting the amount.
- Contributions might also be made on your behalf by your employer.
- You have control over your investments since you may pick where to place your money among the possibilities provided by the plan.
- Self-directed 401(k) plans are transferable, which means you can roll the assets over if you change jobs.
Cons:
Although self-directed 401(k) plans offer some advantages, they also come with a few disadvantages.
- Employers must pay to set up and monitor these plans. The administrative overhead of maintaining loans, early withdrawals, and other transactions requires a great deal of costly oversight.
- Because your employer selects your investing options, you may not have a wide range of possibilities and may be disappointed with the quality. Long-term management can be difficult if you don’t have a diverse set of index funds available.
- The employer also establishes the qualifying criteria, so individuals who are part-time, new, or union members, for example, may be excluded.
- If you resign from the plan before the age of 59 1/2, you may be subject to a 10% penalty, unless you retire in the calendar year in which you reach 55.
Why Are Investors Diversifying Their Portfolio?
Experts agree that the financial market is now even more fragile than pre-2008. Will your retirement portfolio weather the imminent financial crisis? Threats are many. Pick your poison..
The financial system would be in great peril if one or more big banks fail.
“When we get to a downturn, banks won’t have the cushion to absorb the losses. Without a cushion, we will have 2008 and 2009 again.”
Student debt, which has been on a steep rise for years, could figure greatly in the next credit downturn.
“There are parallels to 2008: There are massive amounts of unaffordable loans being made to people who can’t pay them”
The US national debt has spiked $1 trillion in less than 6 months!
“If we keep throwing gas on flames with deficit spending, I worry about how severe the next [economic] downturn is going to be–and whether we have enough bullets left [to fight it],”
Total household debt rose to an all-time high of $13.67 trillion at year-end 2019.
“Any type of secured lending backed by an asset that is overvalued should be a concern… that is what happened with housing.”
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Summary
A Self Directed 401k is an employer-sponsored retirement savings plan that gives employees greater investment flexibility.
Self-directed 401(k)s, in addition to the mutual funds, bonds, and stocks offered by traditional 401(k)s, allow employees to invest in more unconventional assets such as real estate, precious metals, foreign currency, tax liens, equipment leasing, and private placements.
Employees who choose a self-directed 401(k) can make their own buying and selling decisions for their accounts.