Introduction
A Solo 401k vs Self Directed IRA are two options available to many self-directed investors. Both accounts are self-directed, allowing you to invest in any investment permitted by law, including private company shares, real estate, LLCs, and precious metals. However, you may choose one account type over the other based on your situation. What are the differences? When should one be preferred above the other?
Through our extensive research, we have come to the conclusion that there is no universal answer to the question. Instead, you should discover what is ideal depending on your circumstances and investment goals. Are you even eligible for a Solo(401k)? What investments do you intend to make, and does it matter what kind of account you use for them? For better decision making it is imperative to have knowledge about both Self Directed IRA and Solo 401(k);
What is Self Directed IRA?
A self-directed individual retirement account (SDIRA) is a type of IRA that consists of a variety of alternative investments that are prohibited from regular IRAs. Although the account is supervised by a trustee, it’s under the direct control of the account owner, which is why it’s called a self-directed IRA.
Self-directed IRAs can be set up as either traditional or Roth IRAs. But it is to be noted that the two account types have different tax treatments, eligibility requirements, contribution guidelines, and distribution rules. The major difference between a traditional IRA and a Roth IRA is that when you pay the taxes. Traditional IRAs offer an upfront tax credit, but when you start taking distributions in retirement, you must pay taxes on your contributions and gains. However, when you contribute to a Roth IRA, you don’t get a tax break, but your contributions and earnings grow tax-free, and qualified distributions are tax-free as well. Self-directed IRAs are suitable for savvy investors who already master the knowledge of alternate investments and want to diversify in a tax-advantaged account.
What is Solo 401(k)?
A Solo 401(k) is an IRS-approved retirement plan designed for business owners who don’t have any employees. IRS regulations specifically state that, even though you can use the plan to cover you and your spouse, you cannot make contributions to a Solo 401(k) if you have full-time employees. The advantage of a Solo 401(k) is you get to pick your tax advantage such as you can opt for the traditional 401(k), under which contributions may result in a reduction of your income in the year they are made. In that case, contributions in retirement will be taxed as ordinary income. The alternative to it is the Roth Solo 401(k), which offers no initial tax break but allows you to take distributions in retirement tax-free.
In general, opting for a Roth is a better option if you want your income to be higher in retirement. If you think your income will be low in retirement, then opt for the tax break today with a traditional 401(k).
Comparison
Choosing between a self-directed IRA and a solo 401(k) is a critical decision when it comes to self-directing your retirement. A few of the most important differences which are crucial for making a wise decision are listed below;
- Qualification
To be eligible for Solo 401(k) you must be self-employed with no other employees besides the business owner and family/partners. However, for a self-directed IRA, you must be an individual with earned income or funds in a retirement account to roll over.
- Maximum Contribution
A Solo 401k Plan offers both employee and profit-sharing contribution options, whereas a Self-directed IRA has a far smaller yearly contribution cap. Under the Solo 401(k) contribution regulations for 2022, a plan participant who is under 50 years old may make a maximum employee deferral contribution of $20,500. That amount can be made either pre-tax or after-tax (Roth). The business may contribute up to a cumulative maximum of 25% (20% in the case of a sole proprietorship or single member LLC) towards profit-sharing. including the employee deferral, of $61,000.
A plan participant may annually contribute a maximum of $27,000 through an employee deferral if they are 50 years of age or older. You can earn that sum from pre-tax or after-tax (Roth). Including the employee deferral, of $67.5,000. Whereas, a Self-Directed IRA enables an individual with earned income to make contributions of up to $6,000 or $7,000 if they are at least 50 years old and have earned income throughout the year.
- Tax-Free Loan Option
A Solo 401k Plan allows you to borrow up to $50,000 or 50% of the value of your account, depending on which is less. The loan is permitted for the use of any purpose. However, a Self-Directed IRA holder is not allowed to borrow even a dollar from the IRA without triggering a prohibited transaction.
- Administration
For any Solo 401k Plan with less than $250,000 in plan assets, there is no annual tax filing or information return requirement. The plan offers affordable and simple administration. A simple 2-page IRS Form 5500-EZ must be filed when a Solo 401k Plan has a value of more than $250,000. The tax professionals at the IRA Financial Group will assist you throughout the completion of your IRS Form.
- Traditional & ROTH
Within the same Solo 401(k) plan, you can have both traditional and Roth accounts. It also facilitates the conversion of Traditional sums over to Roth as well. However, in a self-directed IRA, you have option of both a Roth IRA and a Traditional IRA. The total contributions are calculated here by adding your individual contributions.
- Better Creditor Protection
In general, a Solo 401(k) Plan provides greater creditor protection than a Traditional IRA. The 2005 Bankruptcy Act generally protects all 401(k) Plan assets from creditor claims in a bankruptcy proceeding. In addition, most states grant greater creditor protection to a Solo 401(k) qualified retirement plan as compared to a Traditional Self-Directed IRA.
- Use of non-recourse leverage & pay no tax
With a Solo 401k Plan, you can invest in real estate using non-recourse funds without triggering the Unrelated Debt Financed Income Rules and the Unrelated Business Taxable Income (UBTI or UBIT) tax (IRC 514). However, the non-recourse leverage exception found in IRC 514 is only applicable to 401(k) qualified retirement plans and not applied to IRAs. In other words, the UBTI tax would be triggered if a Self-Directed SEP IRA would be used to make a real estate investment involving non-recourse financing.
- Investment Details
The Solo 401(k) trustee, who can be the business owner makes investments in the Solo 401(k). A solo 401(k) is exempt from UDFI/UBIT on income from debt-leveraged real estate. However, The self-directed IRA custodian manages investments for self-directed IRAs. The UDFI/UBIT tax, which is levied on income from debt-leveraged real estate, may apply to self-directed IRAs.
- Architecture Plan
The Solo 401k Plan is an open architecture, a self-directed plan that enables you to invest in both traditional and alternative assets, like real estate, by simply writing a check. You will have “checkbook control” over your retirement funds as the Solo 401k Plan’s trustee and will be able to make the investments you want when you want.
The sole reason the Solo 401k plan is special and so popular is that it was created specifically for small businesses. The many features of the plan discussed above are why it is appealing and popular among self-employed business owners. Choosing a Solo 401k vs. Self-Directed IRA LLC makes sense if you are eligible. However, the Self-Directed IRA is a better option if you are not qualified for the plan. The Self-Directed IRA offers more control and investment options as compared to the Traditional IRA.
Conclusion
Based on the differences outlined above Solo 401k vs Self Directed IRA, a solo 401(k) is generally a better choice for someone who is self-employed and yet attempting to maximize contributions amounts. On the other hand, a self-directed IRA is a better option for someone who has already prepared for retirement and who has enough funds in their retirement accounts that can be rolled over and invested via a self-directed IRA as the self-directed IRA is easier and cheaper to establish.
When you initiate self-directing your retirement, one of the most important decisions you must make is whether to open a solo 401(k) or a self-directed IRA. But before you establish your new account, make sure to take into account all of the differences mentioned above.