What advantages do self-directed retirement accounts offer that regular 401(k) plans and traditional and Roth IRAs do not? Well, for some people the range of investments offered in their 401(k) or IRA lack variety. For example, choices may be limited to stocks, mutual funds – including exchange-traded funds and index funds – and bonds. While mutual funds offer a simplified way to diversify, they may not offer broad exposure to different asset classes.

For those who would like more choices and greater flexibility in building their retirement portfolio, investing in a self-directed 401(k) or self-directed IRA will provide this. (For more, see How to Maximize Returns by Choosing the Self-Directed Option.)

How Self-Directed Retirement Accounts Work

The primary difference between a self-directed retirement account and traditional retirement savings vehicles lies in how investments are chosen. With your workplace plan, for instance, your options are limited to the investments your plan administrator selects. When you invest in a self-directed 401(k) or IRA, you’re in control of what you invest in. The types of investments you can choose from include:

  • real estate
  • tax liens
  • private placements
  • precious metals
  • energy investments
  • equipment leasing

This doesn't mean you can invest in just anything. The IRS has some limitations on investment choices with a self-directed account. Insurance and collectibles –such as artwork, antiques, rugs and stamps – can’t be held in a self-directed retirement plan. 

Investing in a Self-Directed 401(k) or IRA

Self-directed IRAs are held by a custodian that you choose, typically a brokerage or investment firm. This custodian holds your IRA assets and executes the purchase or sale of investments on your behalf. Employers can offer a self-directed 401(k) as an alternative to a traditional 401(k) and it’s managed by your plan administrator. 

In terms of the annual contribution limits, the same rules apply to self-directed retirement accounts as to a regular 401(k) or IRA. In 2018 investors can contribute up to $18,500 to a self-directed 401(k) and up to $5,500 to a self-directed IRA. Those limits don’t include additional catch-up contributions of $6,000 and $1,000, respectively, for those aged 50 or older.

The withdrawal rules for each account are also the same. Withdrawals made from a self-directed 401(k) or traditional IRA prior to age 59½ will trigger a 10% early-withdrawal penalty unless an exception applies. Contributions to a self-directed 401(k) or traditional IRA would grow tax deferred until retirement. Required minimum distributions would begin at age 70½ .

Qualified withdrawals from a self-directed Roth IRA would be tax free in retirement, but taxpayers would need to observe the five-year rule for distributions. This rule requires your Roth IRA to be open for at least five years before making withdrawals; otherwise, earnings would be subject to tax. 

Risks of Using a Self-Directed 401(k) or IRA for Retirement

A self-directed retirement account can give you more freedom with your investment choices, but it could also increase your risk exposure if you’re choosing more-volatile investments. If you’re not well versed in real estate or private placements, for example, adding them to your portfolio could backfire if they don’t perform well.

Another risk of which to be aware involves triggering a prohibited transaction within your account. This means using your self-directed plan to invest in a way that violates Internal Revenue Service (IRS) rules. Prohibited transactions include things such as:

  • receiving money directly from an income-producing property in your IRA or 401(k)
  • using real estate held in your account as collateral for a personal loan
  • using property or other investments in your account in a way that benefits you personally
  • borrowing money from your account to repay personal loan obligations or lend to a disqualified person
  • allowing disqualified individuals to maintain a residence in a property you own inside your 401(k) or IRA
  • selling or leasing property within your account to a disqualified person

A disqualified person is a fiduciary of the plan, a person who provides services to the plan and any other entity that may have a financial interest. That includes yourself, your spouse and heirs, the account beneficiary, the account custodian or plan administrator and any company in which you own at least 50% of the voting stock, directly or indirectly. (For more, see Self-Directed IRA: Rules and Regulations.) 

There’s one very important reason to be mindful of avoiding prohibited transactions involving disqualified persons. If the IRS determines that a prohibited transaction has occurred, your account automatically loses its tax-advantaged status. All the money that you’ve invested into a self-directed 401(k) or traditional IRA would be treated as a taxable distribution, leaving you with a potentially huge tax bill.

The Bottom Line

A self-directed 401(k) or IRA may be a good fit, but the rules are complex and sometimes confusing. Before moving forward with one of these plans, it may help to put your retirement strategy in perspective. Reviewing your risk tolerance and goals with your advisor can help you better determine whether a self-directed plan is ideal for achieving your objectives.