The great thing about an Individual 401(k) is you can take a tax-break today on all of your contributions, or use a Roth Individual 401(K) to grow after-tax money tax free without the income restrictions that are placed on a Roth IRA. This is a great advantage for high income earners.
You can use a traditional 401(k), under which all contributions reduce your taxable income in the year they are made. Keep in mind, distributions in retirement will be taxed as ordinary income and we don’t know what those tax rates will be in the future. The alternative option is the Roth Individual 401(k), which offers no tax deduction, but allows you to take distributions in retirement tax-free which can be great for tax planning or wealth transfers.
In general, a Roth is a better option if you expect your income to be higher in retirement, which can often be the case due to Social Security benefits and engrained lifestyles. If you think your income will go down in retirement, opt for the tax break today with a traditional 401(k), especially useful if in a higher federal income tax bracket currently.
The IRS sets the rules about when you can withdrawal the money you put into either type of Individual 401(k) account; however, there are a few exceptions, one of which we go over in our 401(k) loans section. In general, you’ll pay taxes and penalties on any distributions before age 59 ½ unless you meet specific exceptions.
IRS Website: General Distribution Rules