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September 27, 2018

When Should You Use A Solo 401(k) or Self-Directed IRA?

As you may already know, The Real Estate CPA is not the biggest fan of retirement accounts, and frankly, neither am I.

Why would you want to tie up your money in a retirement account that has a number of restrictive rules?

Rules that tell you when and how you can use or withdraw your money. For instance, you can’t start withdrawing your money penalty-free until you’re 59 ½ years of age. What if you want to retire before this point?

What if you want or need these funds for major life purchases?

How do you even know if you’re goint to live that long? (Nothing in life is guaranteed, except death and taxes of course.)

Retirement Accounts Reduce Your Tax Liability

Well, one reason you may choose to use retirement accounts, despite their drawbacks, is because making contributions to traditional retirement accounts will lower your taxable income, and thus your tax liability.

For example, if you’re in the 32% tax bracket and contribute $18,500 to your 401(k), it will reduce your tax liability by $5,920.

In other cases, contributing to traditional retirement accounts can put you in a lower tax bracket.

For example, the 24% tax bracket includes single taxpayers with taxable income ranging from $82,501 to $157,500. This year you have $168,000 in taxable income, which puts you in the 32% tax bracket. By making a $10,500 contribution to your Solo 401(k) it puts you back in the 24% bracket, and saves $3,360 in taxes (($168,000-157,500) x 32%).

Solo 401(k)s

When using a retirement account makes sense, Solo 401(k)s are our weapon of choice.

For starters, Solo 401(k)s (and some regular 401(k)s) give you the option to loan yourself 50% of your 401(k) balance up to $50,000. This allows you to tap into your 401(k) funds, as opposed to taking a third-party loan for major life or business purchases.

Also, with a Solo 401(k), you can contribute up to $55,000 a year between your employee deferral contribution, and employer contribution. If you’re in the 35% tax bracket, this will save you $0.35 for every dollar you contribute, for a total of $19,250 if you make the maximum contribution.

In addition, Solo 401(k)s can be self-directed and used in creative ways to build your real estate portfolio. Whereas a majority of regular 401(k)s only allow you to invest in stocks, bonds, and mutual funds.

Self-Directed IRAs (SDIRAs)

Most IRAs are held with custodians (i.e. Fidelity) that only allow you to invest in traditional investments such as stocks, bonds, and mutual funds. But SDIRAs allow you to invest in a number of alternative investments, including real estate. A popular strategy is using the funds in your SDIRA to become a private lender.

SDIRAs (and some regular IRAs) allow you to draw on these funds early for certain purchases (i.e. your first primary residence). But, unlike Solo 401(k)s, there is no option to take a loan from your IRA.

However, if you contribute to a Roth IRA, while it won’t reduce your tax liability, it will allow you to withdraw your contributions, tax-free at any time, and take your earning out tax-free at retirement.

Other strategies include using Roth IRAs as a vehicle to save for your children’s future, as they can later withdraw the contributions tax and penalty free for any reason should they decide not to attend college.

The Bottom Line

While we try to avoid the use of retirement accounts when possible due to their restrictive rules, we understand they can be a useful tax planning tool.

Since the flexibility of Solo 401(s) allow you to lower your tax liability, loan back a portion of the funds, and get creative with your investment options, it is our weapon of choice.

However, SDIRAs have their advantages so you can’t count them out.

If you interesting in learning more about utilizing one of these accounts, contact a tax professional to discuss how these strategies can impact your specific circumstances.