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How to Set-Up a Self-Directed 401(k)

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on June 13, 2022

Retirement is an important part of life. It is the time when you are not working anymore and have to live on your own savings, which can be quite tricky if they are low. 

Many people cannot afford that kind of lifestyle because their expenses are too high or they simply don’t save enough money for old age. 

If you want to lead a life without financial worries, you should think about saving money for your retirement. Otherwise, you might not be able to enjoy the benefits of your life or even have enough money to eat. 

You can save either by opening up an individual 401(k) plan or joining your company’s 401(k).

What Is a Self-Directed 401(k)?

A self-directed 401(k) is a type of retirement account where the person who has this kind of arrangement can also invest their money.

That’s what makes it different from all other versions because you are not limited to investing your saved-up money into traditional investments like mutual or index funds, stocks, bonds, etc. 

A self-directed 401(k) allows you to invest in almost anything, including real estate, private equity, or even your own business. The only thing you cannot use it for is buying collectibles like art and antiques because they are not considered viable investments. 

There are many different methods of investing money in a self-directed 401(k).

Buying Real Estate

Many people do this to make money when they retire because the rental market in many countries is pretty hot, even during the worst financial crisis. 

The only thing you have to remember about this kind of activity is that if your accounts are still active, you cannot use them for a living. So, if you want to live in a house you own, you have to close the investment accounts and open up another one in your own name.

Private Equity

This kind of activity allows you to buy entire companies or just their shares, which you can later sell when the company starts performing well financially. It is a complicated process, but if you know what you are doing, it is a very lucrative one as well.

Start Your Own Business

The last option you have with your 401(k) plan is to start your own business. You can now use the money saved up from all those years of working and invest them in creating your own company or expanding an existing one.

It is a risk, but if you do it right, the profits you make will be well worth all the effort.

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

If you have a self-directed 401(k) account, you can open up any kind of investment type available in the market. 

You can do almost everything with your money, including buying and selling stocks, purchasing real estate, starting a company, and so on. This wide variety of investments is because the people who created these accounts didn’t want them to have any limitations.

Setting up a self-directed 401(k) is a bit complicated, but if you follow the guidelines given by the IRS, you shouldn’t have any problems. 

The first thing you should do is visit their website and create an account so that everything goes smoothly from thereon. 

You will also have to create an account with the bank where you want your money to be deposited, and this is also very easy to do. 

Once everything is set up, you can start using your self-directed 401(k) and invest in whatever you want.

Benefits of Self-Directed 401(k)

There are many benefits of using your retirement funds to create something or invest them in an existing business. 

The first thing you should know is that the money you put in this account is not taxable, at least not until you withdraw it, which can be decades after opening up the account. 

The interest or dividends created by these investments are also not taxable, so most people who have self-directed 401(k) also invest in real estate.

The second benefit that you get from using these accounts is tax relief. 

If you contribute to your account every year, you can reduce the amount of taxes you pay even though it doesn’t seem like much. But if you keep investing for years, you will notice that the tax relief is substantial.

The third benefit of using self-directed 401(k) plans is that they are quite flexible. 

You can do whatever you want with your money once it’s in there, including changing the beneficiaries if something happens to you, which means that your family members won’t lose everything because of your untimely death.

There are a lot of other benefits that you can get from these accounts, but the ones mentioned above are the main ones. They will help you understand what kind of benefit you can reap from using this method to save up for your retirement.

Risks of Self-Directed 401(k)

If you invest your money in traditional retirement accounts, you do not have to pay any taxes on the interest created by your investments. 

However, it is not like that with these accounts because you will be taxed once you withdraw the money. This is one of the risks associated with this kind of account.

Another thing you should know about self-directed 401(k) accounts is that when you withdraw your money, you have to pay an additional 20% tax on top of whatever taxes you would usually pay. 

The reason for this tax has something to do with how years before, there were constant debates about what should be done with the money you put in these accounts.

And last but not least, with self-directed 401(k)s, you cannot contribute as much money to your account every year. 

This means that although you are making more money than with regular retirement accounts because of the tax relief, you cannot put in as much money. 

This reduces the amount of money you will have when you retire, which is why some people prefer investing their retirement funds in other things like real estate.

As you can see, if you are not careful with your investments, there is a big chance of loss. But if everything goes well, self-directed 401(k)s are the best way to make sure you have enough money to retire with.

A self-directed 401(k) plan is a retirement savings option that gives you the possibility of investing in almost anything through your company's 401(k) account. With this kind of investment, you can start your own business, buy real estate and even invest in gold and other precious metals.
Self-directed 401(k)s have a lot of benefits, but the main ones include tax savings, increased investment options, greater returns than traditional retirement accounts, and so on. One benefit that you get from these accounts is the ability to invest in gold and other precious metals, which isn't allowed with traditional retirement accounts.
Self-directed 401(k)s have a lot of benefits, but they also have a lot of risks. For example, when you withdraw your money from these accounts, you will have to pay a 20% tax on top of whatever taxes you usually pay. Another risk is that you can put a lot of money into one type of investment and lose the entire sum.
To set up a self-directed 401(k) plan, you need two things: an account with the bank where your money will be deposited and an account with the IRS. Although it might seem like a lot of work, setting up such accounts is easy, and once you have them, you don't have to worry about anything else.
You can contribute to a self-directed 401(k) if you have earned income or receive alimony from your spouse. But keep in mind that there is a specific amount that you can contribute to these accounts.

401(k) Plan | A Complete Beginner's Guide

401(k) Meaning

The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.

Traditional 401(k) vs Roth 401(k)

There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.

Contributing to Your 401(k) Retirement Plan

Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.

Pension vs 401(k)

Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.

How Much Should I Contribute to My 401(k)?

Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.

Plan in Advance

Allow us to help you prepare and plan for your retirement ahead. Contact a financial advisor in St Helena, CA or visit our financial advisor page for other details.

401(k) Plan FAQs

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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