Solo 401k vs IRA: Which is Better for High-Income Earners?

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When you’re earning a high income, it’s important to make the most of your money by investing it in the right way. So, which is better: a Solo 401k vs IRA? In this article, we’ll compare the two options and help you decide which is best for you. Keep reading to learn more!

What is a Solo 401k and how does it differ from an IRA?

A Solo 401k Plan is an IRS-approved retirement plan well-matched to business owners who do not have any employees, other than themselves with their spouse also being eligible. Also called the self-employed 401k or individual 401k, the Solo 401k is not a new type of plan. It closely resembles a traditional 401k plan available through many employers but the Solo 401k covers only one employee and the spouse.

Self-employed high income earners seldom know the detailed differences between a Solo 401k vs IRA. The Solo 401k comes with more benefits and fewer restrictions than an IRA or even what major employers offer in a 401k.

We’ll get into why you might want to max out another employer’s 401k below but if you’re only considering an IRA or a Solo 401k, here are three key factors making the Solo 401k the best solution:

  1. You want to contribute much more than the $6,000 you are allowed to contribute to an IRA.
  2. You want to lower your taxes by contributing up to $61,000 tax-deferred dollars ($67,500 if you are over 50). This could drop you into a lower tax bracket!
  3. You want to contribute Roth funds, but your income exceeds what is allowed for a Roth IRA. Note: Your Solo 401k comes with a Roth 401k subaccount.

Any one of these three reasons makes a Solo 401k plan a better fit that will get you saving on taxes and for your future.

Why high income earners should consider using a Solo 401k vs IRA

High income earners have busy lives. Still, they have every reason to take the time to plan their financial future to make the most of their earnings and to assure they have a solid retirement plan. While you don’t want to take shortcuts in this endeavor, following a road map will make the effort quicker and more enjoyable.

A challenge with a Solo 401k vs IRA road map is that not everyone begins from the same place. For instance, some high income individuals are fully self-employed and fund their retirement 100% on their own. Others are working for another company while also working for themselves. And others are working for another company while considering striking out solo full-time but need answers about how to finance their retirement in this situation. Following this simple Solo 401k vs IRA road map will show you where you fit today and the mileposts indicating when it’s time to make adjustments to maximize retirement savings and tax advantages.

1. Contribute enough to earn the full match when your employer offers a 401k match. Do not bypass this opportunity to collect free money. Something very important to know is that your employer’s contributions don’t count toward your Solo 401k annual contribution limit. That means that even if you take the full match from an employer, you can add matching funds from your self-employment that are also tax-deductible to your business.

2. You can contribute to an IRA, but income limits apply. Tax deductions for an IRA are only allowed if you meet the modified adjusted gross income (MAGI) requirements. Also, it is subject to phase out if you have a workplace retirement plan and make above a certain amount. If you are a high income earner, those income limits can eliminate the IRA when deciding between a Solo 401k vs IRA. For high income earners, the Solo 401k is typically the best answer for maximizing both contributions and tax savings.

3. The Solo 401k is the wealth-building option whether you work for another employer or are only self-employed. It typically saves you more on taxes than a 401k held through an employer. When you control the company match, you can max it out, which is something no other employer is going to do. Importantly, you have full control over the investments you make instead of being limited to a handful of mutual funds that another employer allows.

There are only two requirements to open a Solo 401k.

  1. You must own a business.
  2. Your business must have zero employees (employees defined as those who work for you more than 1000 hours per year and receive W-2 wages).

Many sole proprietors, small business owners without employees (except for a spouse), independent contractors, and freelancers typically fit this description.

Here are a few of the key benefits when comparing a Solo 401k vs IRA:

Contribution limits: Contribution limits to both change annually with the Solo 401k setting the bar with about a ten times higher limit than an IRA. That means funding your retirement at a 10X higher amount to grow and compound your investments 10X faster, and 10X the tax savings. Annual contribution limits to an IRA in 2022 are only $6,000 if you are under 50 or $7,000 if you are 50 or older. Solo 401k contribution limits are much higher in 2022 at $61,000 or $67,500 if age 50 or over. If you qualify, you can roll an existing IRA into Solo 401k.

No upper-income limits for Solo 401k contributions. As long as you have self-employment income, you can contribute up to the maximum limit with a Solo 401k. That’s huge in the comparison of Solo 401k vs IRA because high income earners exceeding certain income thresholds are NOT eligible to make tax-deductible contributions to IRAs. Worse yet, many high income earners are not allowed to invest in Roth IRAs at all. However, with a Solo 401k, you may be interested in the Mega Backdoor Roth IRA.

The Solo 401k has better early withdrawal options. Early withdrawal penalties generally apply to both 401ks and IRAs if you withdraw money before age 59. However, the Solo 401k includes the ability to borrow from your retirement account without penalties. Borrowing from an IRA is not available. You also have early retirement options available such as Rule 55, Rule 72(t), and early retirement at Age 59 ½.

When it comes to the Solo 401k vs IRA, both have valuable tax benefits, and you can contribute to both at the same time. However, if you are self-employed or considering self-employment, the Solo 401k offers much stronger benefits for high income earners.

How do you set up a solo 401k and what are the benefits of doing so?

Qualifying and setting up your Solo 401k is very easy.

  1. Have a business. You must be a small business owner, self-employed person, or independent contractor. Your business must have zero employees other than you and a spouse. Employees are defined as those who work for you more than 1000 hours per year and receive W2 wages. You can use contract labor who do not count as employees.
  2. Investment strategy. Your Solo 401k can invest in any number of assets. This is one of the greatest aspects of having complete control over your retirement funds, you get to choose your investments.
  3. Keep your solo 401k investments passive. This is a long-term strategy when investors buy and hold a diversified mix of assets. You purchase and then hang onto a diversified portfolio of assets to generate income, for value appreciation, or both.
  4. Consider pre-tax and Roth contributions when you set up your Solo 401k. Each Solo 401k by Nabers Group comes with a pre-tax and Roth sub-account. This allows another layer of financial freedom and can become part of your retirement strategy. You can make pre-tax and/or Roth contributions, which can benefit your current and future tax deferrals.

Calculate your contribution with our Solo 401k Contribution calculator.

Are there any drawbacks to using a solo 401k instead of an IRA?

If you’re eligible, a Solo 401k is a powerful savings vehicle. As a business owner, you can make both the employee deferral (just like you can with a company you work for) as well as decide and make the employer portion of the contribution. The employer portion (profit sharing) is not limited to a measly 4%, 5%, or 6% that most other employers offer. The IRS allows up to 25% of your compensation from the business (not to exceed 20% of your self-employment income, or 25% of your W-2 income depending on how you structure your business).

You now know that these contributions are significantly higher than contributions to an IRA. They can also be tax-deductible deferrals, or you can elect tax-free Roth earnings.

What is probably news to you is that a Solo 401k also avoids Unrelated Business Income Tax (UBIT) on leveraged investments (common with real estate). If you buy real estate in an IRA and you take on a loan, you will pay UBIT on your net rental proceeds, and/or the net profits from the sale of the property while there’s leverage. A Solo 401k does not pay UBIT.

Self-employment and no employees (other than your spouse) are pretty much the only drawbacks when considering a Solo 401k vs IRA. If you have employees or plan to have employees in the future, an IRA might be a better plan for you.

How to determine which option is better for you – a solo 401k vs IRA?

Self-employed people have the option of choosing between a Solo 401k vs IRA. Both accounts can be self-directed so that you can invest in any investment allowed by law such as real estate, cryptocurrency, precious metals, or private company stock. So, how should you choose one over the other?

There is no universal answer to the question. High income earners often decide based on IRA contribution limits, but you may have other considerations. You now have the information needed to decide what is best for you based on your situation and investment objectives. You also know what it takes to qualify for a Solo 401k and the key benefits that many independent thinkers find attractive.

Set Up Your Self Directed Retirement Plan and Start Investing In Your Future

Do you qualify for a Solo 401k? What investments do you plan to make and does one account type make a difference for your investments? The good news is that either way, Nabers Group has the right answer for you. When you set up your IRA LLC with us, we make the process smooth, compliant, and easy for you so you can get on with your investing and doing deals!

However, high income earners are looking for the best retirement investment vehicle available. If you are or will become self-employed without employees, your best choice is going to be the Solo 401k.

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