The IRS permits tax-preferred retirement accounts to hold alternative investments, including real estate, syndications, and business investments. To expand your retirement portfolio beyond the stock market, you must open a self-directed account.
You can accomplish this through a self-directed IRA or self-directed Solo 401k. While both are retirement accounts, significant distinctions could make one a better fit than the other.
Standard Features of Both IRAs and Solo 401ks
Self-directed accounts permit investments in a host of alternative options without forfeiting the tax pre-preferred treatment. Qualified assets may include purchasing real estate, participating in commercial syndications, buying cryptocurrency, or investing in a business.
You can choose Traditional or Roth accounts. Self-directed accounts can have Traditional or Roth features, giving you tax-deferred or tax-free growth. The IRS authorizes contributions to either or both account types up to the annual maximum limit.
When choosing the best account based on your personal needs and investment objectives, consider the following:
IRA: Any individual with earned income can start or rollover retirement funds into an IRA. The tax-deductibility of contributions depends on your annual income and access to a work-sponsored account
Solo 401K: Small business owners with no employees qualify for an individual or Solo 401k. The only exception to the zero employee rule is spousal income from the same company. You and your spouse can work for the company and participate in the same Solo 401k.
Any income earned from a side job could qualify you as a sole proprietor and, therefore, able to use a Solo 401k as an investment vehicle for retirement funds.
IRAs only accept up to $6,000 annually, with a $1,000 catch-up for anyone over 50.
On the other hand, Solo 401ks permit you to make employee and employer contributions. Employee funds can be up to 100% of income, up to $20,500 annually, with a $6,500 catch-up contribution if you are over 50. In addition to this, you can add funds as the employer. The IRS allows contributions of up to 25% of profits to an aggregate maximum of $61,000 in 2022, not including the catch-up provisions.
While individual 401ks have larger contribution thresholds, the IRS requires regular and substantial deposits to remain active. An IRA does not place any restrictions on the frequency or amounts deposited.
The custodian for self-directed IRAs receives contributions and sends mandatory reports to the IRS. A 401k requires IRS-approved document plans, adding costs to the provider and making 401k fees higher.
The IRS requires all self-directed IRAs to use a third-party custodian who acts as the account trustee.
A 401k may use a third-party trustee, or the owner (you) can be the trustee. You have greater control over the account when you are the trustee, but you accept greater compliance responsibility.
Investment Opportunities and UBIT
Both accounts allow investments in businesses, real estate, and syndications. While there are many tax benefits of expanding your portfolio within a self-directed account, there are also some drawbacks.
IRAs are often subject to UBIT (Unrelated Business Income Tax). UBIT applies when an IRA investment generates business income instead of investment income. The two times when UBIT comes into play is when you invest in an LLC or leveraged real estate.
Solo 401ks are exempt from UBIT on income received from leveraged debt.
In most cases, small business owners gain more benefits from a Solo 401k than an IRA, especially when participating in real estate transactions and commercial syndications.