Although there are eligibility requirements to the Solo 401k and this plan is not for everyone, this post will focus primarily on the components of the plan that make it so attractive when examined next to an IRA LLC.
First, a bit of background
While both a self-directed IRA and a self-directed 401k can allow you to invest retirement funds into almost any asset class, the two structures are unique and covered by different sections of the tax code. It is not uncommon for those seeking the ability to invest their retirement funds into alternative assets to stumble upon the Solo 401k plan by accident. This usually happens while one is researching the self-directed IRA as a result of hearing that such an account can let them a) invest IRA or 401k money into real estate or b) accomplish some similar goal they had in mind for their retirement account. Oftentimes, the discovery of the Solo 401k turns out to be one of two things:
1. a very pleasant surprise as one learns that the plan and its numerous benefits are an option for them
2. a significant disappointment to those who are ineligible for the plan and have to “settle” for an IRA.
Here are some of the major differences in no particular order:
No custodial requirement
While all IRAs must be held at a bank or trust company which serves the role of custodian, there is no such requirement for the Solo 401k. This allows Solo 401k participants to bypass the middleman and control their retirement assets directly. In addition to saving money by eliminating the sometimes very expensive custodian fee schedules, this regulatory distinction also allows for the next two major Solo 401k benefits.
Direct checkbook control
When a custodian holds the assets of an IRA, it is customary for that institution to require written investment direction letters or forms anytime you want to make an IRA transaction. In this custodial model, there is a delay between the submission of the written instructions and the execution of the transaction (if it happens at all – a custodian may deny a perfectly legal transaction). What takes some custodians several business days or more to complete, can be done literally in seconds if one has checkbook control. Note that this is one of those rare instances in which a feature that is great on its own merit actually costs less than the alternative. This is because with checkbook control, you do not have to pay fees for each transaction or bear additional costs based on the asset value of the account.
No need for an LLC
Consideration of self-directed IRA investing often leads to the subject of the IRA LLC. This structure is a combination of a self-directed IRA and an IRA-owned LLC that the IRA account holder manages. The structure is used to obtain indirect checkbook control of the IRA assets. While it can provide many of the benefits of checkbook control, it comes with its own disadvantages. These include LLC administration requirements as well as having to pay setup and ongoing fees to the Secretary of State organization of one or more states. Fees and administration vary from state to state and the minimum annual fee alone can be as high as $800 a year! Since the Solo 401k does not have a custodial requirement, the LLC workaround isn’t necessary for checkbook control.
Higher contribution limits
Contribution limits for a Solo 401k are approximately ten times higher than with an IRA. For 2023, the Solo 401k contribution limit for participants under age 50 is 66,000. For an IRA, that limit is $6,500. Participants over age 50 can contribute up to $73,500 to a Solo 401k, but only $7,500 to an IRA. A higher contribution limit means more potential tax savings and a quicker increase in retirement account asset value. These higher balances can be leveraged to create even more tax deferred (or tax free) growth within the account.
Participant loan feature
Solo 401k participants can borrow up to $50,000 from their plan and use these funds for any reason. There are no taxes or penalties due on the amount borrowed, since the loan is NOT a distribution. This feature is nonexistent with IRAs as borrowing from your IRA is not allowed.
Built-in Roth component
The Solo 401k can house a designated Roth account within the plan. This means that both pre-tax and Roth (post-tax) funds can be contributed to and held within the same plan. On the self-directed IRA side of the coin, the account is either a Traditional (pre-tax) IRA or it is a Roth IRA. To have both fund types with an IRA, multiple IRAs must be opened with a custodian and multiple LLCs may even need to be setup to have checkbook control of those funds.
If you and your spouse work in your business, you can both participate in the same Solo 401k plan. This means your spouse gets his or her own set of contribution limits, which effectively doubles the maximum amount that can be added to the plan each year. This can be a huge benefit for high income earners looking to defer more in taxes and/or grow their retirement account balances quickly. Your spouse also gets a participant loan limit that is independent from your own. With an IRA, each individual must have his or her own account. Combine that fact with the built-in Roth component and a Solo 401k can offer a married couple what might take four IRA LLCs to accomplish!
UDFI tax exemption
Perhaps to keep this post from being so long we will break down each of these benefits in more detail in their own posts. For now, let’s just say the Solo 401k offers additional tax benefits over an IRA in some investment scenarios because of an exemption from unrelated debt financed income (UDFI) tax on debt-financed real estate.
The list of advantages for the Solo 401k compared to an IRA also includes the following:
- greater privacy via the use of a trust rather than an LLC for checkbook control
- greater flexibility with Roth funds as a Roth 401k can be transferred to other designated Roth accounts or to a Roth IRA
- a Solo 401k can also invest in life insurance, while an IRA cannot
- a Solo 401k can usually be setup more quickly than an IRA LLC
- penalties for prohibited transactions are generally less severe with a Solo 401k
For some people considering self-directed investing, any one of these benefits makes the Solo 401k a powerful option. Combining all of these features into one affordable package really makes the Solo 401k a clear choice for many who are eligible for the plan.