When it comes to Self-Directed IRA investing – the practice of investing IRA or other tax-advantaged retirement funds in alternative investments and directing them yourself, personally – there are important differences between the IRA and 401(k) structures.
So knowing where to park your assets and under what circumstances is important for the Self-Directed IRA owner.
First, let’s look at what the IRA and 401(k) have in common:
- Both protect current income and capital gains from taxation, both at the federal and state level.
- Both offer Roth options, which don’t allow you to subtract your contributions from your taxable income for the year, but they do allow your assets within the account to compound tax-free for as long as you live, and make tax-free withdrawals of any assets that have been in the accounts for at least five years.
The rules are the same for both Self-Directed and conventional accounts – it’s just the assets within the Self-Directed accounts that are different.
But IRAs and 401(k)s have some important differences, too. For example:
- Self-Directed 401(k)s may help shelter any leveraged assets from a special tax called unrelated debt-financed income tax. This is a tax on any current income or capital gains attributable to other people’s money, rather than your own. For example: If you buy an investment property for $200,000, and you borrow half of it, and receive $20,000 in rent the first year, and you still owe half the value of the property on the mortgage, then 50 percent of your rental income is subject to unrelated debt-financed income tax.
However, a quirk in the law means that assets held in 401(k) accounts, rather than IRAs, may be exempt from this tax.
Investors who plan to use a lot of leverage in their investing strategies may wish to lean towards a solo 401(k) for that reason – if they don’t plan on taking on any employees other than their spouse!
- 401(k)s allow account owners to take loans. It’s illegal to borrow money directly from your IRA, with a narrow exception for a rollover not exceeding 60 days. But if you sponsor your own solo 401(k) plan, you can set up the plan to allow you to borrow against your 401(k) balance for any reason you like, for up to five years. This may be a convenient source of liquidity for small business owners undergoing a cash crunch, for dealing with a financial emergency or taking advantage of an investment opportunity. Again, the advantage here goes to 401(k) plans.
- IRAs are better vehicles for heirs to inherit. This is because non-spousal beneficiaries who inherit a 401(k) account must empty the account – and pay income taxes on the liquidated assets – within five years of inheriting it. Often, this hits heirs during their own peak earning years, when the tax hit is at its peak. However, non-spousal IRA beneficiaries may be able to stretch the inherited IRA over their remaining expected life spans. This is a much more tax-efficient way to pass assets on to heirs. Advantage: IRAs – particularly Roth IRAs.
- 401(k)s have much higher contribution limits than IRAs. IRA contributions are limited to $5,500 per year, with an additional $1,000 allowable for account owners over age 60 in so-called “catch-up” contributions. 401(k)s, on the other hand, allow for elective contributions of up to $18,000 (or $24,000 total for those over age 60). When you add in total potential matching contributions from the company, you can contribute up to a total combined amount of $54,000.
This is much greater than the potential new money contribution allowable for IRAs. And you can make pre-tax contributions to a solo 401(k) at any income level. In contrast, traditional IRAs limit your ability to make deductible contributions at higher income levels, and high incomes may limit or eliminate your ability to make Roth IRA contributions at all.
However, solo 401(k)s are suitable only for a defined market of self-employed individuals, independent contractors and those who own businesses with no full-time employees other than a spouse.
If this applies to you, then a solo 401(k) may be a terrific small business retirement plan option. Otherwise, you may want to consider a SEP IRA or SIMPLE IRA plan, depending on your circumstances. Both of them support Self-Directed IRA strategies.
American IRA, LLC is a family-owned business that focuses on helping owners of Self-Directed IRA accounts ensure their transactions are handled quickly and accurately and that they are properly documented in accordance with IRS rules. Our offices are located in Charlotte and Asheville, North Carolina, but we work with Self-Directed retirement account investors in all 50 states.
For more information on Self-Directed retirement investing, call American IRA today at 866-7500-IRA(472), or visit us online at www.americanira.com.