What Is an Individual 401k?

If you're self-employed and want to save for retirement, consider an individual 401k. Photo:TaxCredits.net

Whether salaried or self-employed, we all need to be socking money away for retirement. Salaried workers are probably familiar with the 401k or 403b plans available to them. Many self-employed folks, though, don't realize that they can save with an individual 401k, which is similar to a traditional 401k.

In a nutshellFirst off, know that the individual 401k is also known by several other names, which include one-participant 401k, solo 401k, solo k, uni-k, and one-participant k. Aside from the name confusion, it operates very much like a standard employer-sponsored 401k account that employees enjoy at many companies. A key difference is that it's for a self-employed business owner who has no employees (though a spouse can be included, if he or she earns income from the business).

Another difference between a standard 401k and an individual one is the contribution limit. They both carry the same limit for employees, of $18,000 in 2015 (plus an additional $6,000 for those 50 and older). A standard 401k permits employers to offer matching contributions, which typically add a few thousand extra dollars to the employee's account. But with the individual 401k, the account owner (the self-employed sole proprietor) is the employer, and can make additional contributions, too. In 2015, the total contribution limit is 100% of compensation, up to $53,000 (plus an additional $6,000 for those 50 and up). Clearly, you can sock away a lot of money in an individual 401k.

A few other rules apply. For example, the portion of the employer contribution that's tax-deductible is capped at 25% of compensation. And the deductible portion is deductible as a business expense.

Photo: Alan Myers, Flickr.

Traditional or Roth?The individual 401k comes in two flavors, traditional and Roth, which are very much like the traditional IRA and Roth IRA. With the traditional individual 401k, you contribute pre-tax money that reduces your taxable income and, therefore, your tax bill for the year. When you withdraw the money in retirement, it's taxed as ordinary income to you. With the Roth individual 401k, you contribute post-tax money -- i.e., sums that don't offer any upfront tax break. But you do get a tax break, and a potentially big one, when you withdraw from the account in retirement -- because you get to take all the money out of the account tax-free.

Both forms have their advantages. If you're in a very high tax bracket now and expect to be in a low one in retirement, it can be well worth it to defer taxation on a chunk of your income. On the other hand, if you expect to build a very big retirement nest egg over many years with your 401k, the prospect of being able to keep it all, tax-free, is rather appealing.

If you can't decide, you can always open both kinds of accounts and contribute to both, with the contribution limits applying to total contributions made to all 401ks (i.e., you can't contribute up to $53,000 in each of two different 401ks).

Other optionsThe individual 401k has a lot to recommend it, but it's not your only option for saving money as a self-employed person. Two other solid choices are the SEP IRA and the SIMPLE IRA. The SEP has higher contribution limits than the SIMPLE, but generally only lets you contribute up to 20% of self-employed income. A SIMPLE IRA lets you contribute up to 100% of income. So a low-earning person might enjoy a higher contribution via the SIMPLE IRA. Learn more about these options if you're interested, but know that the individual 401k is likely to allow you the biggest contributions.

Get startedNow that you know about your self-employed retirement-account options, be sure to make the most of them. You can establish most of them through a variety of major financial services companies, such as Vanguard and Fidelity Investments.

The article What Is an Individual 401k? originally appeared on Fool.com.

Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.