Contributing regularly to a 401(k) plan is the foundation of retirement savings for many people. You determine the percentage of each paycheck you want to contribute, and you either select a target-date fund based on your expected year of retirement or pick from a relatively limited selection of mutual funds.
But what if you had more control? Suppose you’re a do-it-yourselfer in other areas of your investment plan. In that case, the limited options in a 401(k) can be very constraining – especially when it is often your most significant investment pool. If you prefer to have someone else manage your investments, you may be able to find an advisor that will make recommendations inside your plan, but again, they will be limited.
If you have multiple plans from different employers or a concentrated stock position, it can be difficult to line your 401(k) investing up with your risk tolerance and overall financial picture.
There is another option for investors whose employers offer the ability to self-direct your 401(k).
The Basics of the Self-Directed 401(k)
Self-directed 401(k)s offer automated payroll deductions, and they have the same contribution limits, withdrawal rules, and penalties, and the rollover rules are the same.
The difference is that instead of being limited to whatever funds the administrator has chosen for you, investments can be in a broad range of assets.
Individual stocks and bonds are often available, as well as mutual funds and ETFs. This flexibility means you can craft an investment strategy that more closely mirrors your risk tolerance, goals, and values. It also means that you can view your entire financial picture holistically, and your 401(k) assets can be available to help you solve other portfolio problems.
The Rules Can Be Complicated – But They’re Important
Some transactions are prohibited in self-directed 401(k) plans, and the penalty for not following this rule is that your account will no longer be tax-advantaged. If the IRS determines you are in violation, your investments would be considered taxable, and you’ll be stuck with what could be a very large tax bill.
Since your 401(k) is meant to provide tax-advantage savings for retirement, you can’t invest in anything that will give you an immediate benefit. For instance, while you can own real estate in a self-directed 401(k), you can’t use it to buy your home. The same goes for collectibles, art or other properties – like a second home that you would spend time at. If you’re going to manage the account yourself, you also can’t pay yourself a management fee.
Self-directed 401(k)s prohibit transactions between the owner and what the IRS deems a “disqualified person.” This is someone who has a financial interest in the plan or provides services to the plan. The most obvious person is yourself. This is another manifestation of not being able to use the plan for immediate benefits. For example, you can’t use real estate held in your account as collateral for a personal loan.
Family members, including spouses, parents, grandparents, children, grandchildren, and even the spouses of family members, are also disqualified persons. Your account beneficiary, administrator, and companies in which you own 50% or more of the voting stock are disqualified.
Understanding the Risks
One of the benefits of using a target-date fund or selecting from among the funds an employer or administrator has identified for plan participants is that you have some assurance that they have been vetted and are appropriate. This can be a big time-saver. Identifying investment options, researching stocks, bonds or funds, determining the right asset allocation – and then constantly evaluating the performance and risk in light of market conditions – can be a big responsibility. For most people, the advantage of the 401(k) is the “set it and forget it” convenience.
You’ll be taking on the responsibility for your retirement savings, and a mistake can be very costly. This may not be an issue if you successfully manage investments for yourself. But if you aren’t very familiar with investing, you may want to work with an investment advisor.
Retirement savings is, for most people, a very long-term investment. You’ll want to be sensitive to the selected funds, how much they cost, and how your advisor gets paid. Working with a fee-only financial advisor that gets paid for providing advice and who acts as a fiduciary to always put your interests first is a smart way to build some safeguards into your account.
The Bottom Line
A self-directed 401(k) can offer a way to craft a highly individual investment strategy that works to help you achieve your goals. But it can be complicated to understand what is allowed, and managing the funds in the account requires time, effort, and know-how.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ and owner of True Equity Wealth Management LLC. Email him at [email protected] or fill out a contact form.
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