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Self Directed 401(K) or Self-Employed 401(k) Plan

Table of Content

Last updated on March 13th, 2020
Written by: Rick Pendykoski

What is Self-Directed 401(k)?

A self-directed 401(k) is a private pension plan sponsored by your business. Hence this account type is also known as a self-employed 401(k). It is a qualified retirement plan approved by the IRS. It follows the same rules and requirements as any other 401(k) plan. These rules were initially established in 1981. In 2001 the EGTRRA law was passed. This is commonly referred to as one of the two “Bush Tax Cuts.” This act made significant changes to the IRS code lowering taxes for qualified plans such as a personal 401(k) plan.

Like a self-directed IRA, a self-directed 401(k) also enables you to direct your retirement savings into a host of investment avenues, such as real estate, ppm’s (private placements) money lending, precious metals etc.

With this plan, you have complete flexibility to invest in anything you wish – as long as it is legal. You simply have to write a check and make the investments – they are not confined or stifled as most people are with their traditional brokerage retirement accounts.

Self-directed 401(k)s are perfect for self-employed consultants, contractors, sole proprietors etc.

Self-Directed 401(k) Eligibility Criteria

To open a self-directed 401(k), you must have some self-employed taxable compensation during the current financial year.

How Does Self-Directed 401(k) Work?

There are self-directed 401(k)s and then there are true checkbook controlled self-directed 401(k) plans. Certain financial institutions will assist you to open a new self-directed 401(k) plan. But beware – you will only be allowed to invest in products they represent.

If you have a checkbook controlled self-directed 401(k) (the one’s we establish), the whole alternative investment world awaits. You can certainly invest in “normal” investment vehicles such as stocks, bonds and mutual funds. But you can also invest in so many other products and/or ideas.

  • Funding Self-Directed 401(k)s
    Transfers, personal deferrals (contributions), and profit-sharing are the primary funding sources.

    • Transfers – an individual can transfer previous 401(k) funds, SEP IRA funds, SIMPLE IRA funds, and Traditional IRA funds – in fact, any previous “qualified” funds. Roth IRA funds cannot be transferred.
    • Contributions – personal deferrals are determined by age. If a client is under 50, they can have a personal deferral of 100% of their self-employed income up to $19,500 for 2020 ($19,000 for 2019). For catch-up contributions, which are available to anyone over the age of 50, the limit is an additional $6,500 ($6,000 for 2019), bringing the total contribution limit to $26,000 (up from $25,000 in 2019).
    • Profit-Sharing – the self-directed 401(k) plans we establish are also PSPs or profit-sharing plans. The IRS publication 560 establishes the amount of profit-sharing allowed and includes a step-by-step worksheet. In general terms, the profit-sharing can be up to 25% of the sponsoring entities’ profit.
  • Start Investing
    A self-directed 401(k) empowers a plan participant to invest in a diverse range of investment options such as Real Estate – residential or commercial – rentals, foreclosures raw land, Tax Liens, Precious Metals, Private Placements, Foreign Currency, Hard Money Lending, etc.

Self-Directed 401(k) Investment Options

Self-directed 401(k) plans allow account holders to decide how and where they can invest their pre-tax retirement contributions. With a self-direct 401(k) plan, you are not limited to the pre-approved funds generally offered by traditional 401(k) plans; rather, you get to choose exactly where you want to invest your money. Some of the permissible alternative self-directed 401(K) investments options are but not limited to

  • Real estate (residential or commercial)
  • Loans
  • Buy or Fund your Business
  • Tax liens
  • Private placements
  • Precious metals
  • Energy investments
  • Equipment leasing
  • Foreign currency
  • And MANY other investments

Benefits of Self-Directed 401(k) Plan

  • Any contributions made to these plans, as well as investment returns and earnings, are tax-deferred until withdrawal, and your sponsoring business can receive tax benefits too.
  • You can opt for voluntary elective contributions from your salary, and your employer can also make contributions on your behalf.
  • In the tax year 2020, you are allowed to defer up to $19,500 (up from $19,000 in 2019) or all of your earnings annually (whichever is less), with catch-up contribution limits of $6,500 once you’re over the age of 50.
  • You retain greater control over investments and can choose where your funds will be invested from any of the options offered by the plan.

Self-Directed 401(k) Rules

  • 401(k) Contribution Limits
    Each year, the IRS reviews and adjusts the maximum contribution limits for 401(k) plans and other retirement vehicles. Check the updated 401(k) contribution limits here.
  • Disqualified persons
    The definition of a “disqualified person” extends to any person who either has a financial interest in the plan or is providing services to the plan. The IRS considers you, the 401(k) account holder also as a disqualified person. This means that you cannot use your investments, property, and other investments, to benefit you. You also cannot use your real estate investment in your account as collateral to apply for a personal loan. Your parents, spouse, children (sons, daughters, and sons-in-law), grandparents, grandchildren, and their spouses are considered as disqualified persons. Your account administrator or account custodian, your account beneficiary, and any company in which you own at least 50% of the voting stock (directly or indirectly) are also considered as disqualified persons.
  • Prohibited Transactions
    Under IRS rules, a self-directed 401(k) is prohibited from certain types of investments or transactions. Some examples are:

    • Engaging in a Transaction with a Disqualified Person
      • Plan participant buys a condo and lets daughter live there
      • Plan participant buys part of a business owned by his Father
    • Direct or Indirect Lending of Money
      • Plan participant loans money to his wife or son
      • Father signs a loan guarantee for the Solo 401(k) Plan
    • Receiving Direct or Indirect Benefits of the Plan
      • Plan participant buys a property and charges a management fee
      • Plan participant “fixes” a property himself rather than paying a 3rd non-disqualified party.
      • Plan participant receives a commission for selling a property to the Plan
  • 401(k) Distribution Rules
    Self-directed 401(k) distribution rules are the same as those for any other 401(k) plan.