Last updated on March 29th, 2020
Written by: Rick Pendykoski
A traditional 401(k) account allows you to invest primarily in stocks, mutual funds, certificates of deposits, and bonds. The investment company administering the plan limits the choices. On the other hand, a self-directed 401(K) empowers a plan participant to invest in a diverse range of investment options. Self-directed 401(k) provides investors who have the expertise of investing and knowledge of investment avenues to expand way beyond the traditional boxed products.
Investment Choices Offered Under a Self-Directed 401(k)
- Residential Property (Single Family Homes, Apartments, Duplexes, etc.)
- Commercial Property (Offices, Shops, Sports facilities, Restaurants/Hotels, etc.)
- Developed Land
- Undeveloped or Raw Land
- Mobile Homes
- Deeds of Trust/Mortgages
- Unsecured notes
- Secured notes
- Commercial Paper
- Car Paper
Tax Deeds/Tax Liens
- Tax Deed
- Tax Lien
- Structured Settlements
- Foreign Currency Exchange
- Accounts Receivable
- Equipment Leasing
- Private Equity
- Precious Metals like silver, gold, etc.
- Private limited partnerships, C corporations, and limited liability companies
- Certificate of Deposit
Self-Directed 401(k) Prohibited Transactions and Investments
What is a Prohibited Transaction?
Sections 408 and 475 prohibit a self-directed 401(k) participant from carrying out transactions with a disqualified person.
What Are the Types of Prohibited Transactions?
The following are the types of prohibited transactions:
- Self-dealing prohibited transactions: When a fiduciary, usually you and/or your spouse who has the financial responsibility over the plan engages in a transaction with your 401(k) that benefits you, your immediate family, or your business is referred to as self-dealing and this transaction is prohibited by IRS. An example of self-dealing transaction: You act as a real estate agent to sell your property to your self-directed 401(k) for which you earn a commission too.
- Direct prohibited transactions: Any transaction that would cause you to lose the tax-favored status of your self-directed 401(k) is referred to as direct prohibited transactions. They can be categorized as follows:
- 4975(c)(1)(A): a transaction of sale, exchange, or leasing of any property taking place between the plan and a disqualified person. Example: Your Self-directed 401(k) selling a property to your father.
- 4975(c)(1)(B): a transaction that involves the lending of money or any type of extending credit occurring between the plan and a disqualified person. Example: Your Self-directed 401(k) lending you money to pay off your bills.
- 4975(c)(1)(C): a transaction between the plan and a disqualified person that involved furnishing of goods, services, or facilities. Example: Using your 401(k) funds to buy a house and having your spouse perform the rehab.
- 4975(c)(1)(D): Using or transferring the income or assets of the plan for the benefit of the disqualified person. Example: Taking rent earned by a property earned by your self-directed 401(k) and spending the money for personal use.
- Conflict of interest transactions: This is a conflict of interest between the benefit of your 401(k) plan and you. Example: Your Self-directed 401(k) plan lending money to your real estate agency to expand the agency’s marketing budget.
Who is a Disqualified Person?
The following are the disqualified persons for self-directed 401(k):
- You, the account owner
- Your spouse
- Companies who provide services to the 401(k) plan
- Any fiduciary of the self-directed 401(k) plan (person who makes investment decisions for the plan)
- Your descendants (children, grandchildren, etc.), or and spouses of your lineal descendants (daughter-in-law, son-in-law, etc.), or lineal ascendants (grandparents, parents)
- An entity or corporation that is 50% or more owned, directly or indirectly, by the account owner, the spouse, or any of lineal ascendants or descendants
- An officer, director, 10% or more shareholder or partner, or highly compensated employee of the corporation
- A partner or joint venture owning 10% or more in the capital of profits of the corporation
What Are the Disallowed Investments in Self-Directed 401(K)?
You can invest your self-directed 401(k) in any investment type, except Shares of S Corporations and the following collectibles:
- Alcoholic beverage
- Certain coins
- Musical instruments
What Are the Consequences of a Prohibited Transaction?
If you commit a prohibited transaction even by accident, your Self-directed 401(k) will have to pay federal taxes and penalties. The consequences of a prohibited transaction, as outlined by the IRS are as follows:
- A disqualified person has to pay the initial tax of 15% of the amount involved in the prohibited transaction for each year (or part of a year) in the taxable period.
- If the disqualified person does not make the correction within the taxable period, an additional tax of 100% is applied on the amount involved.
- Both taxes must be paid by any disqualified person involved in carrying out the prohibited transaction.