Can You “Self-Direct” An Employer-Controlled 401(K)?

After decades of hard work, the last thing you want is to see the wealth you put your heart and soul into acquiring evaporate away, be it through taxes, inflation, or even a potential stock market crash. That’s why my clients and I have all been enacting a strategy of diversifying retirement funds outside of the stock market, instead choosing to put money into hard assets like gold or invest in income-producing international real estate.

Americans count on various IRS-approved retirement plans, such as Individual Retirement Arrangements (IRAs) and 401(k), to plan their financial future. Many of my American clients are now actively rolling over their IRAs into “Self-Directed IRAs”, allowing them greater freedom to invest internationally in assets like gold, timber, real estate, and more. They realize that betting your life savings on the stock market and U.S. dollar-denominated assets is a near-death sentence for your financial future and are taking action to protect their wealth.

But you may be wondering, what about my employer-sponsored 401(k) plan? Is there a way to similarly “self-direct” even a 401(k) plan, which is typically controlled by an employer?

Today, we will explore the ins and outs of 401(k) plans, outlining their features and benefits and how you can turn them into their ‘self-directed’ counterparts so that you can take control of your retirement investments. 

UNDERSTANDING EMPLOYER-SPONSORED 401(K) PLANS

Have you ever wondered why companies offer 401(k) plans as common employee benefits? Big paychecks, vacation time, and work culture are also important, but for employees who think long-term, retirement planning plays an essential role. Companies use 401(k) plans as a retainer of talent, ensuring that both the employer and employee benefit from the employment relationship. 

The 401(k) was introduced in 1978 by Ted Benna as an alternative retirement plan. In this plan, both the employer and employee contribute a certain monthly amount. Employers usually provide 'matching contributions,' which are extra contributions on top of the employee's. These matching contributions can be a percentage of the employee's contribution (for example, the employer contributes 50 cents for every dollar the employee invests) or a share of the company's profits. 

The purpose of a 401(k) is twofold: generating returns on investment and offering tax benefits to the employee. Generally, the employer withholds the amount you want deducted from your paycheck and invests it in the 401(k), allowing you to reduce your taxable income while putting that money into stocks, bonds and securities. Companies often match the amount of this contribution up to a certain percentage of the employee’s salary. Some companies may also offer the option to invest with your after-tax dollars and get tax-free withdrawals when you retire with a Roth 401(k).  

HOW DOES A 401(K) WORK?

As mentioned above, 401(k) plans are employer-sponsored and are often included in the benefits package. In the following lines, we will roughly outline how a Traditional 401(k) plan works:

• Step 1: Enrollment. Depending on each company, the 401(k) might allow employees to enroll right away or after a certain period of time has passed since they began their employment, often 30 or 90 days.

• Step 2: Contribution. Once enrolled, contributions are deducted from your gross salary and put into your 401(k) before taxes are applied. Employer matching contributions may also apply. 

• Step 3: Investment. Your contributions are invested by selecting choices from 401(k)’s particular assets, usually limited to mutual funds and ETFs.

• Step 4: Monitoring. As with any investment, please keep track of your returns to see if they meet your investment goals and adjust accordingly. 

• Step 5: Vesting. Vesting refers to your ownership of employer contributions to your 401(k), which vary in each company. For example, after three years of working for the same employer, their contributions may be fully yours to keep. 

• Step 6: Withdrawal. Generally, you must wait until you're over 59 and a half years old to withdraw your funds penalty-free (i.e., a 10% additional tax). However, some exceptions may apply. 

TYPES OF 401(K) PLANS

Much like there are various types of IRAs, there are also various types of 401(k)’s approved by the IRS. Here are some of the most common ones:

• Traditional 401(k) Plans: Your employer gives you a selection of investment options, and your returns are tax-deferred, meaning that you pay tax only after withdrawals.

• Roth 401(k) Plans: It works like a Traditional 401(k) plan does, but you invest after-tax dollars and enjoy tax-free withdrawals after you turn 59 and a half years old.

• SIMPLE 401(k) Plans: This is the option small businesses with 100 or fewer employees offer, including mandatory employer contributions and simplified compliance. 

• One-Participant 401(k) Plans: This is the usual choice by self-employed individuals and business owners with no employees. It also can cover one’s spouse.
   

PROS AND CONS OF A 401(K)

As with any investment product, you can reap profits while facing some level of risk. Below, you will find the pros and cons of 401(k) plans:

PROS

• Employer Matching Contributions: If your employer “matches” an additional contribution to your 401(k), that’s essentially free money that is tough to pass on. For example, if your employer matches up to 5% of your income, your contribution plus theirs will bring the monthly total to 10% of your income, while you are only contributing the 5% amount yourself. 

• High Contribution Limits: If you are under 50, you can contribute up to $23,000 (as of 2024) per year, and if you are older, you can make an additional ‘catch-up’ contribution of $7,500, accounting for a total of $30,500 per year. Therefore, especially in your last working-age years, you can save more aggressively for retirement. IRAs typically have much lower annual limits. 

• Automatic Payroll Deductions: A 401(k) plan allows you to “set it and forget it,” helping you save consistently without manually transferring money each month. 

• Potential for Loans: Some 401(k) plans allow you to borrow against your savings. If you need access to funds for an emergency or a major purchase, you can take out a loan from your 401(k) and repay it over time, typically through payroll deductions. 

CONS

• Limited Investment Options: 401(k) plans generally offer a limited selection of investment options, typically mutual funds, stocks, and bonds. Therefore, options like real estate or private equity are not even presented.

• Possible High Fees: 401(k) plans often come with high administrative and management fees, which can take part of your investment returns over time. Ted Benna conceived these fees as payable by the employer, but more often than not, the employee ends up paying them. 

• Early Withdrawal Penalties: Withdrawing before age 59½ incurs a 10% tax on top of regular income taxes. Remember that exceptions may apply. 

The purpose of a 401(K) is twofold: to generate returns on the investment while simultaneously providing tax benefits for the employee

CAN YOU SELF-DIRECT YOUR 401(K)?

As discussed above, when you work for someone else, you might get a 401(k) sponsored by your employer, but the investment options are limited. Conventional assets like stocks, mutual funds and bonds might not be what you really want, but with your standard 401(K) plan, those are likely to be your only options. Just like some of my American clients have Self-Directed IRAs (SDIRAs), if you have a 401(k), you might want to ‘self-direct’ it to tap into a wider range of assets. This isn’t as straightforward as self-directing your IRA, so first, let’s look at some of the limitations of standard 401(k) plans.

LIMITATIONS OF EMPLOYER-SPONSORED 401(K) PLANS

What if you want to invest in offshore real estate or cryptocurrencies? An employer-sponsored 401(k) does not allow you to do any of that. Instead, you are required to stick to assets like mutual funds, which are highly volatile and intangible. As an investor, I opt for tangible assets with inherent value, such as timber, teak, gold and real estate. 

The most important thing for my clients and me is to be in control of our investments and not let a fund manager you don’t even know determine what’s an appropriate investment for you. It’s true that a 401(k) helps you “set it and forget it,” but this passive style of investing can easily see your assets withered away due to inflation or even future de-dollarization. Wouldn’t you rather spend your retirement days the way you deserve it? 

Also, most employer-sponsored 401(k) plans don’t allow direct rollovers into self-directed accounts while you’re still employed. However, there are exceptions:

• Leaving Your Job: If you leave your current job, you can roll over your 401(k) into a Self-Directed IRA or solo 401(k) if you are a business owner with self-employment income.

• Age-Based Rollovers: Some employers allow older employees nearing retirement to roll over part of their 401(k) into a self-directed account, even while still employed. 

• Previous Employer Funds: If you’ve rolled over funds from a previous employer’s 401(k) into your current plan, you typically can roll those funds into a self-directed account at any time. 

BENEFITS OF SELF-DIRECTING YOUR 401(K)

Before we dive into the benefits of rolling over your 401(k) into a Self-Directed IRA (SDIRA), keep in mind that alternative investments require strict due diligence to maximize your chances of success. A Self-Directed IRA is for you if you want to go beyond conventional assets and pursue higher rewards. The benefits of an SDIRA include:

• Expanded Investment Choices: If your current 401(k) plan only offers limited asset types, rolling it over into a Self-Directed IRA opens up a much wider range of investments. Now, you can diversify your retirement portfolio into alternative assets like real estate, gold, private equity, or even international investments such as timber or offshore properties—potentially offering bigger profits.

• Greater Control: With a traditional 401(k), you typically have a very limited selection of mutual funds from which you can choose to invest. By rolling over into a Self-Directed IRA, you take full control of your financial future. This means you can choose exactly where and how your retirement funds are invested, but it also requires you to conduct thorough research and understand each investment's potential risks and rewards.

• Potential for Higher Returns: While conventional assets like mutual funds might offer modest returns and high volatility, alternative investments like real estate or gold typically offer greater potential for capital appreciation and more stable, tangible value.

• Retaining Tax Advantages: Even though you're moving away from conventional 401(k) assets, the tax advantages of an IRA remain intact. Contributions to a Self-Directed Traditional IRA can still grow tax-deferred (or tax-free in the case of a Roth IRA), allowing you to continue benefitting from tax breaks as you diversify your investments.

401(K) plans often have high administrative and management fees, which can reduce your returns. Ted Benna envisioned these fees as being covered by the employer, but most of the time, it's the employee who ends up paying

HOW TO ROLL OVER YOUR 401(K) INTO A SELF-DIRECTED IRA

Turning your conventional 401(k) into a Self-Directed IRA (SDIRA) allows you to unlock a broader array of investment opportunities and take greater control over your retirement savings. It’s important to note that you cannot roll over a 401(k) into a solo 401(k) unless you have self-employment income and own a business. For most individuals, rolling the funds into a Self-Directed IRA will be the best option. Here's how you can do that:

• Step 1: Understand Your Current 401(k) Plan Limitations. If you're still employed, your employer’s 401(k) plan may not allow you to roll over funds into a self-directed account. However, once you leave your employer, you can typically roll over your 401(k) into a Self-Directed IRA. Certain plans also allow age-based rollovers for older employees who wish to diversify while still employed. Always check the specific rules of your 401(k) plan.

• Step 2: Research and Choose a Custodian. Compare different custodians, including aspects like their reputation, experience, fees, and investment options. Compare custodians based on their reputation, fees, and the range of investment options they support. The custodian will ensure that your IRA stays compliant with IRS regulations and provide the administrative support needed for your investments.

• Step 3: Set Up the Self-Directed 401(k) Account. Once you’ve chosen a custodian, you’ll need to complete the application process and roll over your 401(k) funds into your new Self-Directed IRA. The custodian will guide you through the process to avoid any tax penalties. Once the funds are in your SDIRA, you can start making new contributions or allocating the rolled-over funds to your desired investments.

• Step 4: Determine Your Investment Strategy. With a Self-Directed IRA, you gain access to a wide variety of alternative investments, including real estate, precious metals, private equity, and more. Work with qualified financial advisors to determine your risk tolerance, financial goals, and investment timeline. It’s generally wise to diversify your investments across multiple asset types and jurisdictions to reduce risk. 

• Step 5: Monitor and Manage Your Investments. See if your investments are performing as planned and aligning with your goals. From time to time, you might want to sell some assets and acquire others, as well as keep yourself informed about market conditions and trends. 

CONSIDERATIONS AND POTENTIAL PITFALLS

Before we wrap up this article, I think it’s important to touch on a few key points. Firstly, your Self-Directed IRA (or solo 401(k) if you have a business and self-employment income) must comply with IRS regulations, so make sure your custodian is taking care of that. Also, some transactions are prohibited, so before you put money into certain assets, check whether they are permissible or not. 

As with any investment, Self-Directed IRAs and 401(k) plans entail risks and responsibilities, such as extensive due diligence and potentially increased complexity. Always consult with qualified professionals before investing.

A self-directed 401(K) is ideal for those who want to go beyond conventional assets and seek higher returns. For example, I prefer tangible assets with intrinsic value, such as timber, teak, gold, and real estate

CONCLUSION

In summary, securing a financially stable retirement requires careful planning and strategic investments. Employer-sponsored 401(k) plans offer benefits such as employer matching contributions, high contribution limits, and automatic payroll deductions. However, they come with limitations like restricted investment options and potentially high fees. 

By transitioning to a Self-Directed IRA or solo 401(k) if you are a business owner and meet the self-employment qualifications, you can overcome these limitations and access more investment opportunities, such as real estate, precious metals, and private equity. This shift will help you take control of your financial future and the potential for higher returns, all while maintaining tax advantages.