Setting Up A Self-Direct 401k – Risks, Benefits, And Rules

June 29, 2022
July 3, 2022
Setting Up A Self-Direct 401k – Risks, Benefits, And Rules

There is no avoiding retirement. No matter what job you do, at one point in your life, you want to leave the workforce behind.

During this time, you are not working and must rely solely on your savings, which can be quite challenging if they are low. The cost of such a lifestyle is often too high for many people, or they do not save enough money for the future.

Ideally, you should save money for retirement if you don't want to worry about finances in the future. If you don't save, you might not be able to enjoy life to the fullest or may not even have enough food put on the table.

When thinking about saving, there are two options: You can either open a self-directed 401k plan or join the 401k plan of your employer.

What Is a Self-Directed 401k?

Self-directed 401ks are types of retirement accounts where the owner can also invest their money.

The main difference between it and all other versions is that you do not have to invest your savings in traditional investments like mutual funds, index funds, stocks, bonds, etc.

You can invest in virtually anything with a self-directed 401k, whether it's real estate, venture capital, or your own company. The only items you cannot buy with it are collectibles like art and antiques, as they are not considered good investments.

You can find many ways to invest money in a self-directed 401k, including

Purchasing real estate

Some people do this to make money when they retire because countries like the United States have a hot rental market even in the midst of the worst financial crisis. 

However, you cannot earn a living with real estate as long as your accounts are still active. You must close the investment accounts if you want to own a house and open a new one in your name.

Venture capital

You can buy entire companies or just their shares. If your investment succeeds, you will be able to sell your shares when the company starts doing well financially. The process is complicated, but it can also be extremely lucrative if you know what you are doing.

Invest in Yourself

Your final 401k plan option is to open your own company. Your savings from years of work can now be put to use in starting your own business or expanding an existing one.

Although it is a risky option, if you do it right, the rewards will be worth it.

How Do I Set Up a Self-Directed 401k?

A self-directed 401k account opens the door to any kind of investment option available in the market. You can buy or sell stocks, real estate, or invest in a business. The reason for such a wide range of investments is that the people who set up the accounts did not want any limitations placed on them.

While setting up a self-directed 401k may seem complicated, following the IRS's guidelines would ensure no problems. 

  1. To get started, go to their website and sign up for an account, so everything goes smoothly. 
  2. Additionally, you will need to open an account with the bank where you intend to deposit your money.
  3. After everything is set up, you can start investing in whatever you want with your self-directed 401k.

What Are The Benefits of Self-Directed 401k?

Investing in your retirement funds can offer various benefits. Below are some of them.

  1. The money you put in your investment account is not taxable until you withdraw it, even if you let it inside for a decade.  
  2. Interest and dividends from these investments are also tax-free, making real estate an attractive investment for self-directed 401k investors.
  3. Another advantage of using these accounts is tax relief. Investing in your account every year can reduce your taxes, regardless of how little you invest. Besides, years' worth of investment will result in a significant tax reduction.
  4. Self-directed 401k plans' flexibility is their major benefit. Once you've got your money in there, you can do whatever you want with it, including changing your beneficiaries in case you die. Thus, if you die, your loved ones won't lose everything they own.

While these accounts offer countless other benefits, the list above illustrates what basic advantages you can expect when it comes to saving for retirement.

What are the Risks of Self-Directed 401k?

While a self-directed 401k is one of the best methods of ensuring retirement funds, if you're not careful with your investments, things can also go sideways. Let's check out some of the risks associated with self-direct 401ks.

  1. As long as you invest in traditional retirement plans, you are not taxed on the interest you earn. However, once you withdraw money from these accounts, you will be taxed. 
  2. Once you withdraw your money, you must pay an additional 20% tax on top of your regular taxes.
  3. A self-directed 401k does not allow for yearly contributions as large as a conventional 401k does. By taking advantage of the tax relief, you will be able to generate more money, but you will not be able to invest as much. As a result, you will have less money when you retire, which is why many prefer to invest their retirement money in real estate.

What are the Rules for Self-Directed 401k Plans?

Self-directed 401k plans are subject to the same regulations as traditional 401k plans. However, before starting one, familiarize yourself with the Internal Revenue Service (IRS) rules.

1. The contribution limit for each year

In 2022, you can deduct a maximum of $19,500 from your taxable income to invest in a 401k plan. However, the limit will increase with inflation. At the end of the year, if you're 50 or older, you can elect to defer up to $6,500.

Additionally, your employer can contribute up to a maximum of $61,000 in 2022. The maximum catch-up contribution limit, including employer contributions, is $67,500 for those aged 50 or older.

The limit for your 401k plan contributions shouldn't be an issue if you only work at one company throughout the year because your employer will calculate it. However, if you work for more than one company, going over your limit is easy since each employer doesn't know how much you have already contributed.

It is your responsibility to notify your plan administrator if you overcontributed your 401k and have the excess contribution refunded to you before the next tax deadline. Otherwise, withdrawing the excess contribution before paying tax will not reduce your taxable income. It will also result in the same income being taxed twice. The IRS can also disqualify your plan if you leave excess deferrals in your account.

2. Ineligible investments

You should not take the "self-directed" part of your 401k plan too literally if it's an employer-sponsored plan. Your employer will still be able to limit what you can invest in. A few employers may restrict you to mutual funds only.

You also won't be able to invest in anything for which you might receive a quick return. If you want to buy a house, for instance, you can't use your 401k. Additionally, you cannot come up with your own 401k investment strategy.

However, if your employer permits, you can invest in currencies, gold, stocks, real estate, and other assets. 

3. Deals between related parties

Keep your 401k plan separate from your family members. A family member is defined here as a parent, a grandparent, a child, a grandchild, or a child of a spouse.

It means your 401k investments can't be lent to any of your relatives, used to purchase property for their use, invested in their businesses, or otherwise used to benefit their lives.

4. Distributions

In order to take distributions from a self-directed 401k, you must follow the same rules as you would for a traditional 401k. You may have to pay a 10% IRS penalty tax on top of your regular tax if you withdraw before age 59 unless you qualify for an exemption.

Your employer's 401k plan may let you withdraw funds in emergency situations if you have immediate and serious financial needs. 

As with any other 401k plan, a self-directed 401k plan can be rolled over to another retirement account or IRA if you leave your job. Your money should not be taxable as long as you transfer it into a tax-advantaged account.

Your money should be yours, so you have the right to invest it as you choose, take risks, and earn the rewards. Often employers allow you to make self-directed investments in your 401k plan, so take up the offer. 


Adjusting to retirement can be stressful. However, if you have a plan in place, you can spend your later years with ease. A self-directed retirement fund is the best way to go about it. 401ks offer savers the flexibility to invest pretax retirement contributions as they see fit. In contrast to traditional 401k plans, self-directed 401k plans give you complete control over where your money is invested. In this article, we have outlined everything you need to know about self-directed 401ks so you can decide if they are right for you.

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