Self-directed retirement accounts give you the freedom and power to invest as you see fit, allowing you to put your money behind assets you feel strongly about, even if they aren’t your run-of-the-mill stocks or mutual funds.

Both Self-directed IRAs and Solo 401(k)s, also referred to as self-directed 401(k)s, offer the freedom to invest in alternative assets like real estate or crypto. However, one may be better than the other, depending on your circumstances.

Here’s everything you need to know about both retirement accounts if you’re weighing the benefits of a Solo 401(k) vs. a Self-directed IRA.

What Is a Self-directed IRA?

A Self-directed IRA (SDIRA) is a retirement account that allows you to invest in alternative assets that can’t be held in a standard Roth or traditional IRA, such as real estate, mortgages promissory notes, and precious metals.

Access to alternative assets gives lenders more power over when and how they invest their money. In many cases, SDIRAs allow you to invest in assets with the potential for higher returns over traditional assets like stocks and bonds.

What Is a  Solo 401(k)?

A Solo 401(k) or Individual 401(k) is a retirement plan designed for business owners. It is similar in structure to a traditional 401(k), but you can only contribute to this type of 401(k) if you are self-employed and don’t have any full-time employees. You can also use a Solo 401(k) for a spouse’s retirement.

The primary benefit of a Solo 401(k) is that it offers the same access to alternative investments that an SDIRA does.

Solo 401(k) vs. Self-directed IRAs: Key Differences

Tax Structure

When you open a Self-directed IRA, you can choose between a traditional or Roth account.

If you choose a traditional IRA, your contributions are made with pre-tax dollars, and your money grows tax-deferred until you make qualified distributions. If you choose a Roth IRA, your contributions are made with after-tax dollars. Those dollars continue to grow tax-free, and you can make tax-free withdrawals when retirement comes.

Self-directed 401(k)s are also available as traditional or Roth accounts, but there is a slight difference that sets this type of retirement plan apart from IRAs. If you choose a traditional Solo 401(k), you reap the benefits of tax-deductible contributions with pre-tax savings. However, if you choose a Solo Roth 401(k), you can take advantage of both sides of the coin.

For instance, you can choose to make contributions as the employer under a traditional 401(k), which means upfront tax benefits, while contributing to a Roth account as the employee, allowing you to pick up the tax benefits in retirement when you may be in a higher tax bracket.

It’s wise to speak to a tax or financial professional who can help you determine which type of plan to choose.

Max Contributions

The 2023 maximum contribution limit for a Self-directed IRA is $6,500 if you’re under 50. If you’re over 50, you can contribute an additional $1,000, raising the maximum contribution to $7,500. If you have a Roth Self-directed IRA, you may be subject to another set of IRS contribution limits, which vary based on your tax filing status and modified adjusted gross income.

Solo 401(k) plans have much higher contribution limits. The overall contribution limit for 2023 is $66,000, but your contribution limit will depend on your earned income.

401(k)s are structured such that both employee and employer can contribute to the retirement plan. If you’re self-employed, you play both roles.

As an employee, you can contribute up to 100% as an elective deferral, up to the IRS contribution limit. In 2023, that limit is $22,500 if you’re under 50. If you’re over, you can contribute up to $30,000.

You can also contribute as an employer through non-elective contributions. However, as a self-employed individual, the maximum amount you can contribute varies. You can calculate your maximum contributions by consulting the IRS Publication 560.

Remember that contribution limits for each type of retirement plan can change each year, so always consult the IRS website or a tax professional each year to determine the appropriate contribution limits.

Investment Freedom

Self-directed IRAs and self-directed 401(k)s allow you to invest in traditional assets, like stocks, bonds, and mutual funds. However, with each type of account, you can also take advantage of non-traditional investment opportunities, such as real estate, FOREX, loans and notes, private companies, precious metals, and tax liens.

One primary difference, however, is that a Solo 401(k) provides the freedom to invest without custodial approval (more on that below). IRA account holders can access that same freedom, but only if they establish checkbook control by opening a Self-directed IRA LLC.

Prohibited Transactions and Rules

Both Self-directed IRAs and Solo 401(k)s are subject to a list of federal rules that outlaw certain types of transactions. If you plan to leverage either plan, take time to understand the list of prohibited transactions provided by the IRS.

One of the most important rules to remember deals with disqualified persons. The list of disqualified individuals includes you, the account holder, your spouse, lineal descendants (or your spouse’s), ancestors, or your fiduciary.

The rule specifies that a disqualified individual can not use or benefit from the assets or plan income. For instance, if you plan to invest in property, you cannot use that property as your home or business location. The same is true for any other person considered to be a disqualified individual.

You also cannot invest in certain items, like collectibles, such as art, stamps, antiques, and gems.

If you participate in a prohibited transaction, you must fix the transaction and pay a 15% penalty tax on the total sum involved for each year it’s not corrected. If you fail to fix the issue, you will pay a 100% tax on the sum involved.

Custodial Requirements

When you open a Self-directed IRA, it is held by a custodian or trustee. And unless you have a Self-directed IRA LLC or “checkbook control,” you must pass any investment or movement of funds through your custodian.

You still need a custodian, like Horizon Trust, to set up your self-directed 401(k), but the meaning of the term is different. In this case, the custodian acts only as the entity that holds your assets. They don’t maintain any authority over how or when you invest. Even with checkbook control, though, the same IRS investment rules and prohibited transactions still apply.

Though you can set your Solo 401(k) up through a custodian, like Horizon Trust, the custodian simply holds the assets.

Liquidity and Loan Options

You cannot typically borrow against an IRA — self-directed or otherwise — though there are exceptions to the rule.

If you have a Roth IRA, for example, you can take a withdrawal against contributions without penalty as long as your account has been open for five years. You also may be able to withdraw from an IRA — traditional or Roth — if you qualify for one of the few exceptions, such as buying your first home or funding higher education expenses for yourself or your spouse, children, or grandchildren.

When it comes to accessing your retirement funds early, a Solo 401(k) carries an advantage. You can typically borrow up to $50,000 or 50% (the lesser of the two) from your solo account. If you borrow from the account, you have five years to repay the loan unless the funds go towards purchasing your primary residence. In that case, you usually have up to 30 years to repay the loan.

Establishing an LLC

Control is a driving reason so many investors choose Self-directed IRAs and self-directed 401(k)s. If you open a Self-directed IRA, the best way to maintain complete control is to open an IRA LLC. Doing so allows you to link your retirement account to the LLC and maintain what’s known as checkbook control. That means you, as the administrative head of the LLC, can actively participate in investment opportunities without passing them to your retirement account’s custodian.

There’s no need to establish an LLC unless it fits your self-employment objectives.

Which One Is Right for Me?

Both a Self-directed IRA and a Solo 401(k) can give you more control of your retirement investments. One of the major factors in determining which is best for you is your employment status.

If you are self-employed and don’t have any full-time employees, a  Solo 401(k) can give you many of the same benefits of a Self-directed IRA but with higher contribution limits, increased investment freedom, and flexibility when it comes to funding access and tax benefits.

If you’re not self-employed or currently have or intend to bring on full-time employees, then a Self-directed IRA will be the right choice. The best thing to do is to consider your employment and retirement goals. Speaking to a financial expert can also help you contextualize those goals and determine which retirement plan best meets your needs.