I think it’s probably pretty obvious to all of us nowadays that one of the not-so-secret secrets to building wealth is being able to have as much control over the wealth building process as possible. However, due to the way that the system for investing in retirement is set up in the United States it is VERY difficult to do this. Instead of our parent’s defined pension option, we must learn how to use a self-directed 401(k) and IRA.
Your 401(k)
By now you’re hopefully well-versed on how the 401(k) works. Gratefully enough the US government lets us set aside funds prior to being taxed in a qualified retirement account such as a 401(k). That of course is good!
What isn’t good is that the company that also provides our paycheck, if we are a W-2 employee, also essentially picks who gets to administer our retirement account, determine our investment options and what we have to pay them for the privilege.
Don’t get me wrong, in comparison with NOT having the option for a 401(k) (or 403(b) if you work in government or work for a non-profit organization) having the ability to invest pre-tax is still one of the best deals in town. BUT…not having total control over where your money goes or who’s administering it on your behalf is a serious liability.
The Downside of The Current 401(k) System
Let me tell you an interesting story but one that sadly is probably being played out WAY too often every single day in the America. My wife’s employer provides a menu of well over a dozen investment options for her 403 (b) investment account. Variety is great, right? Well, that’s what I initially thought until I started to look into where she might want to put her hard-earned money.
After what took me two weeks of nightly research…no kidding, two weeks…I finally found an investment option that made sense for my wife.
Unfortunately, the BEST investment scenario that I could come up with was to go with the ‘cheapest’ available option that I could find which consisted of paying a 1.5% management fee to have the PRIVELEGE to be able to invest in low-cost Index Funds.
That is out right LUNACY in this day and age and sadly, predatory based on the availability of low-cost mutual funds and Index Funds.
Along the way, I also recorded the other options as well so as to capture the whole picture of what was available to my wife and her colleagues. What it revealed was beyond scary. It felt downright wrong bordering on unethical.
What it boiled down to was within the dozen or so management companies that offered retirement options, there were multiple configurations of 2% to 5% management fee investment options in annuities and other insurance products of all things. All in all, there was not one low-cost option that specialized in simply providing Index Funds.
All the mutual funds that were offered were expensive actively managed mutual funds. I started to think that the 403(b) program that my wife’s company set up was more for the advantage of the investment companies than the employees it was set up to help.
Plan Administrators are Unaware How Their Own 401(k) Works
I took all of my research and called the plan administrator at my wife’s organization to tell her what I found out. I ended up talking to a very pleasant individual who knew very little about the program.
She admitted that this wasn’t something she knew much about and didn’t even have much of her own money in the program.
I was told that most employees, including leadership, didn’t even take advantage of the program so there was real little motivation for anyone to do anything different than what was being done. She also went on to tell me that it took a ton of work simply just to put the existing program into place and no one had the interest to step in to change it.
Sadly, I think that this gets played out way too often in America as it relates to our employer administered 401(k) system. The bottom line is that not every employee participates in their provided program and of those that do they aren’t substantially committed in a large enough manner per se to demand a higher level of performance or accountability.
In fact, I worked at an entity that had over 300 employees and there were only 3…count them…3 people who maxed out their investment every year, myself being one of them.
A Little Known Aspect of the ERISA Act of 1974
So what can any of us do about this situation? How can we have more control of our own retirement investment destiny? Interesting enough within the same magical legislation that gave us the 401(k) in the first place, the Employee Retirement Income Security Act of 1974, or ERISA Act, there was also a little known allowance for us employees to be able to administer our own retirement investments.
Effectively what this allows is for us to petition our employers for the allowance to establish a guardian account with an outside provider who specializes in self-directed investments.
If you’re lucky enough to have an employer that will allow you to establish a self-directed 401(k) plan within the infrastructure of their program, then it’s a very easy process.
All you’d need to do is find a 401(k) guardian where you can set up a valid account and start investing inside that plan.
This self-directed plan will now operate just like a conventional 401(k) from the standpoint that you can make tax-deferred retirement investments from your W-2 payroll job.
Using the Self-Directed 401(k) Allowance
In the event that our employers either currently offer or will offer a self-directed 401(k) option, then we’re in business. If that’s not a possibility, there’s still a way to take advantage of self-directed retirement investment but you’ll have to do it outside of your employer’s plan and investment funds wouldn’t be pre-tax. This would be the exact process that you may have already gone through in establishing a taxable IRA account with a provider such as Vanguard.
However, for the opportunity to make controlled investments in assets that you want access to and choose because they meet YOUR needs and not those of the investment company, then this certainly is an option you need to consider.
The Benefit of Self-Directed 401(k)’s
So what’s the benefit of self-directed retirement investments?
The first is the freedom to make investments in products that you want to invest in, not simply because they’re available or that they’re the least of the worse investment options, but because they’re the best investment decisions.
The second is that you could design an investment portfolio that meets your needs with investments in alternative assets like real estate.
It also allows you to purchase individual stocks and create your own retirement portfolio. Another important benefit, it allows you to take a direct ownership stake in assets like private businesses and real estate. That’s right. You can purchase individual stock, own shares of private businesses and even hold the title to individual real estate assets.
You Choose The Investments You Make
So let’s break this down. Primarily a self-directed 401(k) or self-directed IRA lets you control the investments that you make for yourself within your retirement account. This includes investing in individual stocks, real estate, development land, promissory notes, tax lien certificates, precious metals, cryptocurrency, water rights, mineral rights, oil and gas, LLC membership interest, and livestock
In fact, the Internal Revenue Code Section 4975 states that the only investments NOT allowed in retirement accounts are collectibles and life insurance.
Let’s use an example. In a conventional 401(k) if you wanted to invest in real estate you were relegated in choosing a Real Estate Investment Trust (REIT) option IF one was even provided in your conventional IRA.
Just like other REIT’s or mutual fund investments you were more than likely having to pay an additional ‘management fee’ for the privilege of owning this asset, perhaps a 1 or 2% annual fee. This fee goes to the REIT to pay the overhead of owning and operating the asset including paying for the CEO’s bonus and private jet. I wish I was even trying to be funny.
Invest in Real Estate and Own It
Now let’s use another example. Let’s say that you had a self-directed 401(k) and you wanted to invest in real estate.
You could actually use your self-directed 401(k) to purchase that sweet little 4-unit in the town you live in and watch the monthly rents roll back into your 401(k) every month. As a result, you could own the title to that property and literally drive by it each and every day and keep an eye on it.
Sound too good to be true? The self-directed 401(k) real estate rules allow individuals to buy a specialty property such as a lake property, hold the ownership within your 401(k) and use it as a long-term rental property.
When it’s time to withdraw assets from you 401(k) upon retirement age, you can withdraw it and then retain full ownership as you would conventionally. Now just so that this doesn’t sound too good to be true, be forewarned that one of the stipulations is that you can’t ‘self-deal’ while the property is within your 401(k).
No Self-Dealing
The self-directed 401(k) prohibited transactions include what is called ‘self-dealing’. This means that you can’t take any advantage of this property such as living in it yourself at any point of owning it within your 401(k) or having a family member rent it from you. Nor are you allowed to maintain or manage the property by yourself.
This is strictly meant to be an arms length owned asset where although you own the title to the property you’re not in any other way allowed to utilize it or take advantage of that ownership as you would real estate that you own conventionally.
A lot of people when they hear this think that this is unfair and too restrictive. However, let’s be real.
The government doesn’t want you to be able to buy a duplex and park ‘Junior’ in one unit of it until your 59 ½ and be tax advantaged for doing so.
Nor do they want you to use a tax advantaged tool to be able to buy a waterfront property and have you and your relatives use it as you would other conventional real estate.
If that is the goal they would prefer you do that the same way that everybody else does. They want you to treat this as a hardcore investment strategy.
Other Limitations – Disqualified Persons and Prohibited Transactions
In addition, there are also several other limitations. These are identified as ‘Disqualified Persons’ and ‘Prohibited Transactions’. I briefly identified above that direct relatives are ‘Disqualified Persons’ but what would be some ‘Prohibited Transactions’?
The most common one as we’ve discussed is that you can’t use a property for personal use but you also can’t sell your own property to your self-directed 401(k), you can’t use a property as security for a loan, nor can you loan funds to your parents or your spouse’s business.
Conclusion
Notwithstanding the Disqualified Persons or Prohibited Transactions aspects, self-directed 401(k)’s and IRA’s are VERY powerful tools that are available to accelerate the wealth building process if they serve your investment needs and time horizons.
They are important to consider for two very crucial reasons; (1) They allow US to control where OUR investments go based on OUR best interest.
Not the best interest or the convenience of the investment community simply putting together a slate of investment options that may or may not be in our best interest or that serve our investment goals. (2)
They allow us to invest in assets that may not be available to us in conventional 401(k)’s and IRA’s. These could take the shape of individual stocks and bonds, direct real estate ownership and even ownership of shares in private businesses.
In order to accelerate wealth building, we have to be in control to the greatest extent possible of where and how we invest our money.
Self-directed 401(k)’s and self-directed IRA’s are possible solutions that give us that option.
