You may have heard about self-directed solo 401(k) plans. But what can they invest in and what is the process?
Many people fail to understand the added complexity and compliance. But they can work well in the right situation.
In this article, we will discuss how investments work for self-directed plans and point out a few compliance issues. We will also show you why we believe that self-directed assets are usually better in a self-directed IRA. Let’s get started!
Some Background
If you set up a 401(k) plan with Fidelity, Schwab or Vanguard, you likely used their plan document. As such, you are essentially “captive” to their investment platform. But what if you want to invest in other asset classes beyond traditional stocks and mutual funds? This is when you’ll have to look for a custom self-directed plan.
A self-directed 401(k) plan is a retirement structure that offer participants much greater control over their investment options compared to traditional 401(k) plans. A self-directed 401(k) offers participants the opportunity to diversify their portfolios by investing in a wider range of assets, such as real estate, private equity, precious metals, and even cryptocurrency, depending on the specific plan terms. This increased flexibility makes the self-directed 401(k) an appealing option for people looking to customize their investment strategies and potentially achieve higher returns.
But self-directed plans come with greater compliance. The compliance issues involve year-end asset valuations, bonding requirements, and a more complex form 5500 filing.
What Can a Solo 401(k) Invest In?
A solo 401(k) plan can invest in almost anything. Here are several:
- traditional equities (stocks, bonds, ETFs)
- real estate
- digital assets like cryptocurrencies
- syndications
- hedge funds
- private equity
- promissory notes
- tax liens
- mortgage notes
- gold and precious metals
Because you are the trustee and plan administrator, you are responsible for doing investment due diligence. Emparion is not allowed to be your compliance officer. That’s why we strongly recommend you work with your CPA and/or tax advisor to review your deals.
What are Non-Qualified Assets?
Non-qualifying plan assets are investments that may cause compliance issues within a retirement plan. These assets can trigger additional reporting requirements. If a retirement plan holds too many non-qualifying assets, a bond or fiduciary liability insurance may be required.
Examples of non-qualifying plan assets include collectibles, real estate used personally, and certain closely held business interests. Investments lacking a readily available market value, such as private equity, can also be non-qualifying. These assets can complicate plan administration and reporting.
Retirement plans must ensure accurate valuation of non-qualifying assets. The IRS requires fair market value to be reported annually. Failure to provide accurate valuations can lead to tax penalties or disqualification.
If non-qualifying assets exceed 5% of plan holdings, additional safeguards may be necessary. Fiduciary liability insurance or a surety bond can help meet compliance. Without proper protection, the plan administrator could face legal and financial risks.
Understanding non-qualifying plan assets helps retirement investors avoid compliance issues. Proper planning ensures tax advantages remain intact while reducing potential penalties. Consulting a professional can help navigate complex investment rules.
How Do I Use the Funds for Self-Directed Assets?
As noted above, if you set your plan up with Vanguard Fidelity or Schwab, you are likely captive to their platform and cannot invest in self-directed assets. You’ll need an amended plan to allow you to purchase non-qualified assets.
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*Emparion is not affiliated with, endorsed by, or sponsored by these institutions.*
But suppose you have a plan that allows self-directed investments but are currently buying stocks, mutual funds, and other qualifying assets at one of the above providers. In that case, you must get the funds out of that account and over to your new investment. You can do this in one of two ways:
- Transfer the money directly out of the custodian account. You will work with your current custodian on how to transfer those funds directly out.
- Open up a bank account under the name of the 401(k) plan. Then, transfer the assets from your current custodian to this bank account. From there, you can gain checkbook control or at least be able to wire or ACH the funds out of that account and into your new investment.
Some people may directly transfer the money out of the custodian account and not open up a separate bank account. But in most situations, this won’t work.
If you’re investing in rental real estate, syndications, promissory notes, and many other asset classes, you will likely receive a distribution of funds back to your plan. If you don’t have a separate bank account, then you will have no place to deposit these amounts. That’s why using a separate bank account makes the most sense.
For example, let’s assume you acquired rental real estate. You will need a separate bank account to receive rent payments and also to pay rental expenses, such as property taxes, insurance, etc.
You may have invested in private equity, a syndication, or a real estate partnership that issues distributions to investors. In this case, you must have a bank account to deposit those checks or receive the fund distribution.
How Do I Set Up a Bank Account for My Self-Directed 401(k)?
In theory, you can open up a bank account for your solo 401(k) at any bank. However, if you go to some of the large banks like Bank of America, Chase, or Wells Fargo, they often won’t understand what you’re trying to accomplish. That’s why we typically recommend you go to a specialty bank that offers custom solutions.
Many large and small banks don’t have much experience opening a bank account for a retirement plan. Here are a few tips to make this process easier for you:
Is a Cash Balance or Defined Benefit Plan Right For You?
- It is important that you open the account by the name of the 401(k) plan on the adoption agreement. This will help you avoid any taxation when it comes to distributions.
- Use the EIN you received when the 401(k) plan was established. Do NOT use your social security # or the EIN for your business.
- Tell the bank that you want to open a “Trust” bank account, not a business or personal account. Often, the bank may assume you want to set up a 401k plan with the bank as the plan trustee. This is, of course, not the case, as you are the plan trustee.
- In the majority of cases, the bank will not need your plan document. But to be safe, print off the Adoption Agreement and bring it to the bank when you set up the account. Please realize that it is a lengthy document. Any other documents they might need were provided to you when the plan was established.
- The business owner, as trustee, can direct all investments and decide on the bank or brokerage to use. The bank will not serve as the trustee of any alternative investments.
- You could be required to explain that a self-directed 401(k) is a retirement trust and that you are serving as the trustee.
Make sure they are aware that 401(k) plans are funded via a trust that is established to retain the plan’s assets. At least one trustee is responsible for the trust’s investments and operational activities.
Make sure you keep your 401(k) assets completely separate from your personal assets and any other business assets you might have. You should not commingle retirement funds with any other class of funds. Commingled accounts can result in immediate taxation and should be avoided at all costs.
Do You Recommend any Banks?
While we don’t endorse any banks or financial institutions, many of our clients use Titan Bank or Solera Bank. These banks are very familiar with self-directed assets. In addition, they have rather simple set up processes. You can find out more about them below:
Valuation Concerns
To value non-qualified assets in a retirement plan, you typically use their “fair market value,” which means determining their current market price based on readily available information or, if necessary, getting an appraisal from a qualified professional, as the IRS mandates that all plan assets must be valued at fair market value, not cost basis. This applies to both qualified and non-qualified assets within a retirement plan.
Key points about valuing non-qualified assets:
- Market-based valuation: For publicly traded securities, the fair market value is usually the closing price on the exchange where they are traded.
- Appraisals for illiquid assets: If the non-qualified asset is not readily traded on a market (like real estate, artwork, or private investments), an independent appraisal is usually required to determine fair market value.
- Consideration of risk and liquidity: When valuing non-qualified assets, it’s important to consider their inherent risk profile and how easily they can be converted to cash, as these factors can affect their true market value.
Take a look at what the IRS says about the valuation of plan assets here.
Additional Compliance Concerns
Bonding Requirements
If your plan has non-qualifying plan assets, you must have a fidelity bond that covers at least the combined market value of all non-qualifying assets in the plan.
When your plan has “non-qualifying” assets that exceed 5% of total assets, then you must maintain a fidelity bond for the combined value of all “non-qualified assets.”
If you don’t have fidelity bond coverage or you let it lapse, you may lose your “small plan” exemption and could be required to have an annual plan audit. These audits are costly and time consuming.
If the 401(k) plan is subject to ERISA, the business must have a fidelity bond that covers at least 10% of the net qualified plan assets.
However, if the plan has less than 100 employees, the DOL will waive the audit requirements if the plan assets have less than 5% of its net market value from “non-qualifying assets.” The plan must have a fidelity bond that encompasses 100% of the market value of the non-qualifying plan assets.
Form 5500 Requirements
ERISA typically doesn’t cover one person plans. You would then be filing Form 5500-EZ. However, if your defined benefit plan holds non-qualifying assets then you are required to submit Form 5500.
IRA is Often a Better Option
While you can use a 401(k) plan to invest in what’s called non-qualified assets. But as a general rule, we strongly recommend against it for several reasons. In the majority of situations, there is just not a compelling reason to do it unless you have no other retirement accounts, and you are willing to accept the compliance headaches.
Most of our clients already have a lot of money in IRAs and 401(k)s. These plans can easily allow for self-directed assets. Because they’re essentially defined contribution plans and not defined benefit plans, they do not have valuation issues or funding problems like a defined benefit plan. As such, they are much better structures for investing in real estate.
While we don’t recommend any companies, here are a few self-directed IRA companies that our clients have used:
| Pros | Cons |
| Flexible Investment Options | Valuation Concerns |
| Significant Funding Levels | Administrative Issues |
| Tax Deductible Contributions | Bonding Requirement |
| Alternative Asset Options | Higher Plan Fees |
Final Thoughts
A self-directed 401(k) gives investors more control over their retirement savings. With proper planning, it can offer greater diversification and growth. However, understanding the rules is essential to avoid costly mistakes.
Before opening a self-directed 401(k), research investment options carefully. Alternative assets can provide unique opportunities but come with added risks. Staying informed and working with professionals ensures compliance and long-term success.
Ultimately, a self-directed 401(k) is a powerful tool for experienced investors. It allows flexibility, but discipline is necessary for success. With careful management, it can significantly enhance your retirement strategy.
If these compliance issues are addressed, then non-qualifying assets can be a great option through a 401(k) or other retirement structure.
