Most people know that they don’t want to work for the rest of their life. However, they also want to enjoy their golden years without fretting about whether they can afford their current lifestyle. This problem plagues many people in the years leading up to retirement, and solopreneurs are not immune to it. Preparing and making wise investments for retirement is key, but how do you decide between the various options like a solo 401(k) vs a self-directed IRA?
If you have been on the fence about which type of retirement savings account is right for you, here’s the breakdown you’ve been looking for and some advice to help you get started.
Solo 401(k)
While there is a lot of confusion surrounding the different types of retirement investments out there today, a Solo 401(k) is still one of the best choices. To qualify, you must be a self-employed business owner with no other employees besides yourself and your spouse or partners. This makes it a bit more restrictive, but it is a great option for self-employed people.
What sets the Solo 401(k) apart when it comes to retirement savings accounts? In a nutshell, it is the high contribution maximum between the contributions of both the employee and employer. You have a $66,000 maximum annual contribution which allows you to earn $174,000 of income before you fully max out this type of account.
In addition, you can make additional catch-up contributions of $7,500 if you are age 50 or over. We can look forward to even more catch-up contribution changes from the Secure Act 2.0, too. Starting in 2025, those aged 60-63 will be able to make additional contributions of $10,000 or 50% more than the regular catch-up amount, whichever is greater.
One of the best parts of the Solo 401(k) is that you don’t need to go through a third party to make investments. You can be your own trustee, though platforms like Retire4one make the process super simple.
Solopreneurs will have responsibility and flexibility in their accounts, but it does not have to be a scary endeavor. In fact, many solopreneurs enjoy the control they have over their savings.
Pros:
- High maximum contribution limits
- Traditional or Roth options
- Profit sharing with the business (up to 25%)
- Ability to take out a tax-free loan
- Easy to administer
- Flexibility on investments
Cons:
- Early withdrawals suffer a 10 percent tax penalty
- May be more expensive to initially set up
Self-Directed IRA
A self-directed IRA is a bit more stringent on who can open this type of account and how much they can contribute to it. For a self-directed IRA, you must be an individual with earned income or you must have funds in a pre-existing retirement account to roll over into this type of account. While that includes most self-employed people, you might be disappointed by the other limits put on these types of accounts.
For example, the annual IRA contribution maximum for 2023 is $6,500. Self-employed individuals who need to prepare more heavily for retirement might want to consider switching to a Solo 401(k) instead.
If you are age of 50 or over, you can secure an additional $1,000 in contributions each year, which is something to keep in mind. You are eligible to make these catch-up contributions in the calendar year in which you turn 50. Thus, someone who is 49 can contribute catch-up contributions as long as they will be turning 50 later that year.
Pros:
- Traditional or Roth options
- Less expensive to set up and administer
- Potential for high return on your investments and some protection
Cons:
- Early withdrawals from the IRA suffer a 10% tax penalty
- More stringent regulations with paperwork and fees
- May require taxes for unrelated debt-financing income
- Not as diversified as other types of accounts
- Requires special custodians but does not offer investment advice
Solo 401(k) vs. Self-Directed IRA
In general, a Solo(k) tends to be the better choice for self-employed people who are interested in preparing heavily for their retirement. Even though the setup and maintenance may be a bit more expensive, you still have plenty of ways to save. You can contribute far more to a Solo 401(k) vs a self-directed IRA ($66,000 versus $6,500).
You can also use it as a tax-free loan if you need to borrow money for any reason. Loans can be for a term of up to 5 years, and the interest is paid back into your account. These funds can be used to make purchases, pay a medical bill, cover unexpected costs, or any other of the various expenses you’ll encounter as a business owner.
On the other hand, a self-directed IRA may require you to pay taxes on unrelated debt-financing income.
Of course, you also want to make sure that your investments are safe and protected. While there are no guarantees when it comes to investing in the market, you are generally safer with a Solo(k) than with a self-directed IRA. Self-directed IRAs are not as diversified and are often riskier, while a Solo(k) offers more diversification and therefore less risk.
Both have traditional and Roth options, depending on what tax bracket you are in now and where you will be in retirement. Consult with a professional to help you decide which option is the right fit for you.
Another benefit is that the business can contribute to your Solo(k). Profit sharing up to 25% is an option, helping you to more fully fund your account out of business funds instead of solely basing it off your overall salary. In order to max out your contributions, you would need to earn at least $174,000 of self-employed net earned income annually.
Set Up and Manage your Solo(k) with Ease
The good news is that setting up a Solo(k) for yourself does not have to be time-consuming or overly difficult, as you might have expected retirement planning to be. Retire4one makes it easy to set up your Solo(k) from the comfort of your couch or home office–all without ever having to pick up the phone.
Our site is uniquely equipped to help solopreneurs set up a Solo 401(k) without taking too much of your valuable time. Set up will take just 3 to 5 minutes of your time, depending on how much you research the curated selection of fund options we provide.
Visit our website today to learn more about how Retire4one can help you to start saving for your future!