Choosing Your Path to Retirement: Self-Directed IRA vs Self-Directed 401(k) Explained

by Peter Halm

A Self-Directed IRA (Individual Retirement Account) and a Self-Directed 401(k) are both types of retirement accounts that allow for a broader range of investment options compared to traditional IRAs and 401(k)s. However, there are key differences between the two:

1. Eligibility and Establishment:

   • Self-Directed IRA: Anyone with earned income can open a Self-Directed IRA. It's established through a custodian that allows for self-directed investments.
   • Self-Directed 401(k): Also known as a Solo 401(k), this is primarily for self-employed individuals with no full-time employees other than the business owner and their spouse. It’s established by the individual who acts as both the employer and the employee. So long as you meet the eligibility requirements (the presence of self-employment activities and absence of full-time employees), you can start a business to open a Solo 401(k)

2. Contribution Limits:

   • Self-Directed IRA: The contribution limits for a Self-Directed IRA are typically lower than for a Solo 401(k). For 2024, the limit is $7,000 per year, or $8,000 if you're age 50 or older.
   • Self-Directed 401(k): The contribution limits are higher. As of 2024, you can contribute up to $69,000 per year, or $76,500 if you're age 50 or older. This includes both employee and employer contributions.

3. Loan Provisions:

   • Self-Directed IRA: Does not allow you to take loans against your IRA.
   • Self-Directed 401(k): Allows you to take a loan against it, up to 50% of the account's value or $50,000, whichever is less.

4. Roth Options:

   • Self-Directed IRA: Offers a Roth option, where contributions are made after-tax, and qualified distributions are tax-free.
   • Self-Directed 401(k): Some Solo 401(k) plans also offer a Roth option, but this is not as common.

5. Required Minimum Distributions (RMDs):

   • Both account types require RMDs starting at age 72. However, if you’re still working and don't own more than 5% of the business employing you, you can delay RMDs from a 401(k) until retirement.

6. Investment Options:

   • Both accounts offer similar broad investment options, including real estate, precious metals, private placements, and more, beyond the traditional stocks and bonds. However, the custodian or plan administrator might have specific restrictions.

7. Costs and Complexity:

   • Self-Directed IRA: Might have higher custodian fees and can be more complex to manage due to the need for a custodian.
   • Self-Directed 401(k): Generally has lower administrative costs and can be easier to manage due to no custodial requirement.

8. Custodial Requirements:

   • Self-Directed IRA: Requires a custodian to hold the IRA assets.
   • Self-Directed 401(k): Does not require a custodian; you can act as your own trustee.

9. UBIT and UDFI Taxes:

   • Self-Directed IRA: Subject to Unrelated Business Income Tax (UBIT) and Unrelated Debt-Financed Income (UDFI) taxes in certain investment scenarios.
   • Self-Directed 401(k): Exempt from UDFI when using leverage to purchase real estate.

Choosing between a Self-Directed IRA and a Self-Directed 401(k) depends on your employment status, the amount you want to contribute annually, your need for loans from your retirement account, and your preferred investment strategy. It's advisable to consult with a financial advisor or tax professional to determine which option aligns best with your individual retirement goals and circumstances.

Real Estate as a Business using a Solo 401(k)

A real estate investor that is self-employed can treat the business as passive or active.

1. Passive Real Estate Investing (Schedule E): When real estate investment is treated as passive, income and losses are reported on Schedule E of IRS Form 1040. This typically applies to rental property income and expenses. Passive activity is generally not subject to self-employment taxes. However, losses might be limited under passive activity loss rules.

2. Active Real Estate Business (Schedule C): If the real estate activity is conducted as an active business (like a real estate dealer who frequently buys and sells properties, or a developer), the income and expenses are reported on Schedule C. This is considered self-employment income, and thus, subject to self-employment tax (which includes both Social Security and Medicare taxes, totaling approximately 15.3%).

3. Sole Proprietorship or Single-Member LLC Decision: A sole proprietor or a single-member LLC can choose to report on Schedule C if the real estate activity qualifies as an active business. This choice might be influenced by factors such as the nature and frequency of real estate transactions, the investor's role in the business, and the intention to grow it as an active commercial enterprise.

4. Tax Implications: Choosing Schedule C may result in higher tax liability due to self-employment taxes, but it could also provide certain benefits, such as the ability to contribute more to a self-employed retirement plan like a Solo 401(k). Conversely, reporting on Schedule E might limit the investor's ability to claim certain losses if they are not actively participating in the real estate business.

5. Professional Advice: Given the complexity of tax laws and their implications on your finances, it’s advisable to consult with a tax professional. They can help determine the most beneficial way to report your real estate income based on your specific circumstances and long-term financial goals.

In conclusion, the choice between a Self-Directed IRA and a Self-Directed 401(k) is a pivotal decision for any investor, particularly those in the realm of real estate. Each account offers unique benefits and limitations, tailored to different investor profiles. A Self-Directed IRA provides a broad investment spectrum with specific custodial requirements and is suitable for individuals with any employment status. On the other hand, a Self-Directed 401(k), or Solo 401(k), is an excellent option for self-employed individuals or small business owners without full-time employees, offering higher contribution limits, loan opportunities, and certain tax advantages, particularly in real estate investments.

For real estate investors, whether operating passively or actively, these self-directed options open doors to leveraging retirement funds in diverse real estate ventures. However, it’s essential to understand the tax implications and operational nuances of each choice—whether reporting as a passive investor on Schedule E or as an active business on Schedule C. Navigating these options wisely, ideally with professional advice, can significantly impact the efficiency and growth of your real estate investments within your retirement strategy. Remember, your approach to real estate investing and the choice of retirement account should align with your overall financial objectives, offering a balanced blend of growth, risk management, and tax efficiency.