If you are self-employed and want to set up a tax-saving pension then you might want to take advantage of Solo IRAs. The Solo 401k and Roth IRA are also options for self-employed persons, but all three have their own set of advantages, disadvantages and related tax requirements that need to be considered before opening a particular account.
Recently, a friend of mine found herself having to decide which one of these plans would be best for ensuring her financial future. Her goal was to maximize the return on her investments, while keeping her tax liability as low as possible.
My friend is a self-employed video producer who works with her husband and has no employees. After some painstaking research, my friend learned that she was eligible to open a Solo IRA or Solo 401k. Interestingly, she discovered that the Solo 401k would not have been available if she had employees. Since she hired free-lance contractors from time to time, she was concerned that this might disqualify her from opening a Solo 401k, but learned that this was not the case.
Setting up a Roth IRA was also an option, since anyone is allowed to own one.
At first she was confused about the difference between a Solo IRA, a traditional IRA and a Roth IRA. But then she learned that there is no difference between a traditional and a Solo IRA. They are the same thing. She would be allowed to make contributions to this plan that could be deducted from her taxable income for that year. Any profits earned by the IRA would be tax deferred until she withdrew them at retirement. At that time she would be required to pay regular income taxes on the disbursements.
Then she took a look at the Roth IRA. Contributions made to a Roth would come from earned income that has already been taxed. In this case, however, the contribution would not be tax deductible. So why would she consider setting up this type of IRA? Because she would never pay any more taxes on the profits she made with this plan. And when she takes her retirement, she can withdraw up to the total amount of her contributions plus her earnings without having to pay taxes.
Now she wanted know about funding each plan. If she decided to set up either a Solo IRA or Solo 401k, she learned that, in 2008, her maximum allowable contribution would be around $100,000 for her and her husband (the maximum changes with each tax year). If she decided to set up a Roth, currently she and her husband would be limited to a maximum contribution of $10,000.
The picture was now beginning to come together. But there still was the question of how her contributions were going to be invested. Being a very "hands-on" person, she wanted to have control and flexibility in deciding how to invest her money. She knew she needed to diversify, but given the current state of our economy, she wanted something a little less risky than just stocks and bonds. Investing in real estate had always been one of her dreams but she wasn't sure that would be possible with an IRA or 401k.
After some more research, she was very excited to discover that she could set up either a Self-Directed IRA or Self-Directed 401k that would precisely give her the control and flexibility she was looking for. She also found out that there are managing companies that handle self-directed plans and allow clients to run their own investment portfolio. These companies act as "custodian" of your IRA, keeping required records, providing you and the IRS with necessary reports and maintaining compliance with federal regulations.
The moral of the story: Taking advantage of a Solo IRA/401k versus a Roth IRA will depend on your income and tax situation. If you make a lot of money and want to defer taxes on that income then a Solo IRA or 401k is an appropriate choice. If you want to pay taxes now and not later, then a Roth IRA may be your answer. In either case, you should consult with a financial advisor who can expertly steer you toward a plan that fits your personal needs and goals.
As for my friend, I'm happy to report that she found a management company that not only helped her setup a self-directed IRA, but also located real estate deals that have quickly doubled (an soon to be tripled) her initial contribution. And the best part is that the profits that go back into her Solo IRA are not subject to capital gains taxes...or the uncertainty of the current market.
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