Invest Your Way: Our Self-Directed 401k Guide

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Retirement accounts are a scary subject.

Why? Because the unknown is terrifying. A lot of us don’t know much about our retirement account options. Heck, sometimes I forget whether I have a traditional or a Roth IRA… and how those differ.   

If you’re in the dark about your current retirement accounts, then you probably don’t know much about a far less common option: the self-directed 401(k).

Self-directed 401(k)s probably won’t remain a mystery for much longer, though. As of 2017, 18% of Vanguard’s defined contribution plans offered self-directed options. The larger the plan, the higher that percentage goes. So if you don’t already have the option to open one, you could soon!

What Is a Self-Directed 401(k)?

Scott Kallish, a financial advisor with FMB Advisors, a financial advisory practice of Ameriprise Financial Services Inc., gave me a basic definition of a self-directed 401(k):

“A 401(k) is a very regulated retirement account that must follow strict guidelines and
calculations,” Kallish said. “Some 401(k)s may include a self-directed component, or a ‘brokerage window,’ where the 401(k) participant[s] can take it upon themselves to place all sorts of investments above and beyond anything the 401(k) plan sponsor approved for the 401(k).”

You may already know that traditional 401(k)s offer you a set number of investment options — namely mutual funds, stocks and bonds.

Self-directed 401(k)s give you many more options. You can invest in a wide range of things through the brokerage window.

Want to own real estate? With a self-directed 401(k), you can.

Want to be like Ron Swanson in “Parks and Recreation” and invest in gold? You can put gold into your self-directed 401(k), too.

The choices go on and on. (More on the limitations later.)

Think of retirement accounts like eating at a restaurant.

Setting up a traditional 401(k) is like ordering from the menu at a restaurant. The meal is good, but you’re limited to what’s on the menu.

Choosing a self-directed 401(k) is like going to an international supermarket to choose what you want to eat. You can buy all the ingredients you want to prepare your own dishes, and the wide variety of food makes your meal much more creative!

Am I Eligible for a Self-Directed 401(k)?

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If you’re setting up a plan through your employer, your eligibility depends on their standards.

As a general rule of thumb, you must be at least 21 years old and have worked for your employer at least 1,000 hours per year over a certain number of years.

Most companies only allow employees who have been with the company for a while and already have a hefty 401(k) plan balance to create a self-directed 401(k) plan.

While this may seem unfair, having control over your own investments is a lot of responsibility. The idea is that if you’re loyal to the company and have experience with your retirement account, you’re rewarded with the brokerage window.

How Does a Self-Directed 401(k) Work?

A self-directed 401(k) may sound too complicated to understand. But the rules are actually surprisingly simple.

“The IRS approved taking a traditional 401(k) plan and adding a self-directed brokerage window to it to create a self-directed 401(k) plan,” Kallish said.

So, a 401(k) with a self-directed component follows all the same rules as any other 401(k). For example, if you have a self-directed plan, you still have to adhere to the same annual contribution limit as someone who has a traditional 401(k). That means you can contribute $19,000 in 2019.

While there aren’t any different rules for self-directed plans per se, there are a few additional regulations and details for the brokerage window.

First, you can’t invest in collectibles. If you were thinking about using your self-directed 401(k) plan to invest in high-end sports cars or works of art… sorry!

Second, you can’t use your investment to work with a “disqualified person.”

What exactly is a disqualified person? Let’s say a plan participant buys a condo and lets their daughter live there or buys part of a business owned by their grandfather.

That would be illegal because family members cannot live or work in the assets owned within your 401(k) brokerage window.

Third, the direct or indirect lending of money is prohibited. For example, a mother can’t sign a loan guarantee for her son as part of the self-directed 401(k) plan.

Fourth, you can’t receive direct or indirect benefits from your self-directed plan. You can’t receive a commission for selling a property to your own plan.

However, if you own a small business and administer your own self-directed 401(k), you have even more flexibility. Basically, you can legally invest in anything except life insurance!

Yes, you read that correctly. You might be able to set up a self-directed 401(k) even if you don’t have an employer to go through.

How Can I Start My Own Self-Directed 401(k)?

People who want to open a self-directed brokerage window through their company can go through their company’s process. What if you’re self-employed or own your own small business, though? How can you open your own self-directed 401(k)?

First, open a solo 401(k). Keep in mind, you can only open this account if you’re a business owner with no employees.

Then you set it up so that your solo 401(k) has a brokerage window for self-directed investments.

Do you own your own business but have employees? Then opening a self-directed solo 401(k) isn’t an option. (Unless your only employee is your spouse! You’ve got to love a loophole.)

You can open a self-directed solo 401(k) through an investment broker like Fidelity, where you’ll find a wide range of investment options.

Plan carefully, though. It’s important to decide which investment broker is the perfect fit for you and your company. Vanguard, Charles Schwab and E-Trade, among many others, also offer individual 401(k) plans. Each company’s fees, investment options and rules vary.

It all depends on your priorities! Check out an incredibly comprehensive review of various investment brokers’ solo 401(k) plans on The Biglaw Investor.

Contributing to Your Self-Directed Solo 401(k)

You’ve chosen your investment broker. They’ve helped you set up an account. Now, how do you actually contribute money to your self-directed solo 401(k)?

  • First, determine how much you want to contribute to your account annually. Most companies will have a tool to help you make this decision, such as Fidelity’s handy contribution calculator.
  • Most investment brokers will have you fill out a salary reduction agreement form. This document records how much of your salary you want to contribute each month. Some brokers give other options. For example, if you have a self-directed 401(k) with Fidelity, you can simply print and fill out a form and snail mail it with a check each time you want to contribute.
  • If you already have a retirement account, you may be able to rollover your assets to your self-directed 401(k). You’ll want to check with both the company that handles your original retirement account and the company that controls your self-directed 401(k) to check both sides’ rules about rolling assets over.

What Are the Pros and Cons of Opening a Self-Directed 401(k)?

Retirement accounts are very complex, so the pros and cons could go on for pages and pages. But we’ll keep it simple and just cover the main points.

The Pros of a Self-Directed 401(k)

  • First of all, you have much more control over your investments than you would with a traditional 401(k). If you have a lot of experience and knowledge, you may not want to be limited by your company’s investment options. You can put all your knowledge to good use and make the most of your money!
  • My favorite pro? Self-directed 401(k)s are portable. “You can roll them over if you change jobs, rather than establishing a new plan for every employer,” Kallish points out.
    If you think you’ll be changing jobs soon and/or frequently, this portability could spare you a major headache each time you get a new job.

The Cons of a Self-Directed 401(k)

  • You know that freedom and control that comes with a self-directed plan that so many love? It can also be a con. Going back to the restaurant analogy, the thought of selecting and preparing a meal from the plethora of choices at the international supermarket may feel so overwhelming that sitting down at a table and ordering off a menu sounds infinitely easier and safer. And if you don’t have a lot of investment knowledge, there’s a lot of room for mistakes.
  • As mentioned above, if your plan is provided through your company, the company decides who is and isn’t eligible. Being at their mercy can be annoying and can be seen as another con.
  • Last but certainly not least, there’s potential for fraud. People conducting Ponzi schemes sometimes target self-directed 401(k) participants, because they might be unknowledgeable. In fact, it got so bad a few years back that the Securities and Exchange Commission (SEC) put out an investors alert about potential fraud.
    The easiest way to avoid fraud is to use a well-established 401(k) firm that’s been in business for a while, with a highly rated track record and few (to no) complaints. The 401(k) firm must also allow for the brokerage window for self-directed investing inside the 401(k) plan. They can regulate your investments and keep you safe.

Will this be the year you open a self-directed 401(k)?

Laura Grace Tarpley is a freelance writer and an editor for FluentU. Follow her on Twitter @lgtarpley.

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