If a self-directed 401(k) is on your radar, you’re not alone. This type of account is becoming increasingly popular among investors who want greater control as they save for retirement. That’s particularly true as markets, and therefore the investments held in standard 401(k)s, are becoming increasingly volatile.

On the surface, a self-directed 401(k) is a special type of retirement account that makes it easier to hedge against market volatility by investing in assets, like real estate, private equity, and precious metals..

We’ll help you understand how a self-directed 401(k) differs from a traditional 401(k), including the type of assets available, the advantages of this type of account, and how you can get started.

What Is a Self-directed 401(k)?

A self-directed 401(k), also known as a Solo 401(k) or individual 401(k), is a special type of retirement account for self-employed individuals and small business owners who have no employees other than their spouses.

This type of retirement account lets you invest in a broad range of alternative assets not available to standard 401(k) holders. Often, this makes it easier to achieve higher returns and hedge against growing market risks.

When you open a self-directed 401(k), you are in control of investment decisions. As such, a self-directed 401(k) is an attractive option for savvy investors or those who have in-depth knowledge of certain markets, like real estate or private equity, and want to leverage that expertise to grow their retirement account.

Differences from a Standard 401(k)

The two primary differences between a self-directed 401(k) and its standard counterpart are asset availability and management.

Investment options

In general, you can only hold publicly traded stocks, bonds, and mutual funds in a standard 401(k). With a self-directed 401(k), you can invest in a much wider range of alternative assets, including:

• Real estate
• Precious metals
• Private Equity
• Tax liens
• Trust deeds
• Promissory notes
• Cryptocurrency
• Limited partnerships
• Oil and gas rights
• Commodities
• Livestock

Management & Control

Your standard 401(k) is a management plan. Even though the account holder can generally decide how their funds are invested, such as choosing a mutual fund, asset availability is largely guided by the plan administrator. For some, this is beneficial: the financial institute that holds the account performs due diligence on investment decisions, acting as a fiduciary. The trade-off, however, is true control of your funds.

If you open a self-directed 401(k), you control your investment decisions. Your custodian, or the entity that holds the assets for you, manages administrative details and ensures your account complies with IRS requirements, but it does not make investment decisions on your behalf. This allows you to take advantage of investment opportunities and leverage your expertise to invest in assets and drive account growth.

Advantages of a Self-Directed 401(k)

There are several benefits associated with a self-directed 401(k), particularly when compared to a standard 401(k). If you’re on the fence about whether or not a self-directed 401(k) is right for you, consider the following advantages:

• Control. As discussed above, investors have complete control over their investment choices. This level of autonomy, when combined with proper due diligence, can yield higher returns when compared to standard 401(k)s.
• Tax-advantaged. Like a regular 401(k), a self-directed account allows you to take advantage of tax-deferred growth while funds are in the account.

Solo 401(k) can be designated as Traditional or Roth.  If you have a traditional account, contributions are made with pre-tax dollars, and withdrawals are taxed. If you have a Roth account, contributions are made with after-tax dollars, and withdrawals are tax-free.

• Diversification. The range of alternative assets available via a self-directed 401(k) makes it easy to diversify your portfolio and hedge against risks commonly associated with assets traded on the open market. For instance, you can have a mix of stocks, bonds, and mutual funds while simultaneously holding less volatile assets, like real estate and mortgage notes.
• Potential for higher returns. Alternative investments like real estate and private equity can deliver much higher (and potentially faster) returns than is typically seen with common assets. This can be a boon to any account holder, though it’s particularly beneficial to those who may have started saving for retirement later in life.

Self-directed 401(k) Contribution Limits

Self-directed 401(k)s have the same contribution limits as standard 401(k)s. In 2024, individuals can contribute up to $23,000 per year. Individuals age 50 or older can make an additional $7,500 “catch-up” contribution, raising the total limit to $30,500. The combined limit, which includes employer contributions, is $69,000 ($76,500 for those 50 or older).

Contributions limits can change yearly, often increasing to reflect cost of living adjustments. If you have a retirement account, make it a point to check contribution limits annually.

Self-directed 401(k) Prohibited Transactions

The IRS sets specific rules regarding what type of transactions can take place within a Solo 401(k). Failure to adhere to these restrictions can result in significant penalties.

Prohibited transactions center on the concept of “disqualified persons,” which include the account holder, their spouse, ascendants (parents, grandparents), descendants (children, grandchildren), the account custodian, and any entity in which the account holder or another disqualified person has significant ownership.

Any transaction that engages a disqualified person is considered prohibited. This includes:

• Use of assets held in the self-directed 401(k), such as living in a home purchased or vacationing in an investment property held by the account.
• Self-dealing, or engaging in any transaction that directly benefits the account holder or disqualified person. For instance, the account holder can’t sell their home to the 401(k) as an investment property. Likewise, an account holder couldn’t hire their son to complete renovations on commercial property held in the account.

How to Set Up a Self-Directed 401(k)

If you’re a business owner with no employees (other than a spouse) or are otherwise self-employed, you can open a self-directed 401(k) by following these steps:

1. Choose a custodian. The first step in opening your account is to find a custodian or financial entity that offers this unique type of account.

As you shop around for the right custodian, it’s helpful to keep your investment strategy in mind and identify a custodian with experience in the asset(s) that interest you. In addition, always check and compare custodian fees, which vary.

2. Establish the plan. Work with your chosen custodian to establish and adopt a plan agreement. At this time, you can also choose whether you want the account designated as a Traditional or Roth account.

3. Fund the account. If you have an existing retirement account, you can transfer or rollover funds from that account to your new self-directed 401(k). This can be advantageous, as the amount transferred does not count towards your annual contribution.

If you don’t have a retirement account or prefer not to move funds, you can fund the account by moving money from a savings or checking account. However, funding the account using this method will count towards your annual contribution for that year.

4. Choose your investments. Once your account is funded, you can begin investing in your chosen assets. Keep in mind that self-directed investments are subject to your own due diligence.

FAQs

Who is eligible to open a self-directed 401(k) plan?

Small business owners with no employees (other than a spouse) and self-employed individuals can open a self-directed 401(k). If you are a small business owner who intends to hire at least one employer, other than your spouse, it’s wise to consider an alternative retirement account, such as a Savings Incentive Match Plan for Employees (SIMPLE) IRA or Simplified Employee Pension Plan (SEP).

If you’re not self-employed or a small business owner but still want to maintain control over your investments, consider opening a self-directed IRA.

Are there any tax implications or considerations with a self-directed 401(k)?

Yes, there are several tax implications to consider when opening a self-directed 401(k).  Primarily, these accounts offer tax-free growth. If you have a Traditional Solo 401(k), taxes are deferred until you start taking withdrawals. If you have a Roth Solo 401(k), the account is funded with after-tax dollars, so qualified withdrawals are tax-free.

It’s also important to consider prohibited transactions and early withdrawal penalties, as both of these activities can result in tax penalties.

Can I rollover funds from another retirement account into a self-directed 401(k)?

Yes, you can rollover funds from other retirement accounts, including standard 401(k)s, 403(b)s, and IRAs.  To avoid any penalties, it’s best to make a direct rollover, which moves funds without you taking possession of the money.

If you choose to take an indirect rollover and temporarily take possession of the funds, make sure you deposit funds into the new account within 60 days to avoid tax implications and penalties.

What Investments Are Allowed in a Self-Directed 401(k)?

Self-directed 401(k)s can hold alternative assets not available to standard 401(k) holders. Alternative assets include but aren’t limited to real estate, cryptocurrency, precious metals, mortgage notes, private equity, commodities, and livestock.