Self-Directed 401(k) Rules and Options

Self-directed brokerage accounts give 401(k) investors more options

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Hands-on investors enrolled in a 401(k), 403(b), or 457 plan are often interested in seeking additional alternatives to their retirement plan’s core investment lineup. But most Americans are unaware of an offering potentially available in their employer's retirement plan—the self-directed brokerage account (SDBA).

A self-directed brokerage account is an option that opens up access to a network of mutual funds. Some SDBAs may let you invest in stocks, bonds, and exchange-traded funds, as well. When you place your retirement savings in an account like this, your investments are allocated to investments apart from those available in the core plan.

According to Aon Hewitt, approximately 40% of retirement plans offer SDBAs. Hewitt also found that only around 3% to 4% of retirement plan participants with access actually use this option. Retirement savers using these accounts generally have higher incomes and higher plan balances, with the average account balance falling just under $250k.

Is a Self-Directed Brokerage Account Right for You?

Many benefits exist when investing in an SDBA, but it isn't a good choice for everyone. Here's how to know if it's right for you.

You Prefer Having Greater Flexibility

The self-directed brokerage account gives investors access to a wider range of investment choices than the default ones presented in the plan. If you're unimpressed or dissatisfied with the investment choices available in your retirement plan, check to see if a self-directed 401(k) is available. It could be a viable alternative rather than settling with your core investment lineup.

The accounts may come in the form of a "mutual fund window" providing access to thousands of funds to choose from. Some plans give investors access to a more flexible “brokerage window” account that may allow you to invest in mutual funds, exchange-traded funds, and even individual stocks and bonds. The main concept is to give you more choices if you are a hands-on investor.

You Want Access to a Wider Range of Asset Classes

Many retirement plans allow participants to allocate a portion of their total retirement savings to these self-directed accounts. This can be beneficial if you're generally satisfied with your retirement plan’s overall investment lineup but want access to additional asset classes like emerging markets, international small-cap, or alternative asset classes such as real estate and commodities.

Your Fund Lineup Has Above-Average Fees and Expenses

Workplace retirement plans require fee disclosures be sent to participants, and understanding your associated costs is important. The general trend in the retirement plan industry is leaning toward lower costs. But lower-cost options might be available in a self-directed brokerage account if the fees in your retirement plan at work are too expensive.

Disadvantages to Investing in a Self-Directed Brokerage Account

For all the advantages, there are a few downsides. Consider these potential pitfalls before you invest in an SDBA.

Managing Your Own Retirement Savings Requires Discipline

Self-directed brokerage accounts are designed for advanced investors who know how to research and manage their investments. The Financial Industry Regulatory Authority, Inc. (FINRA) cautions investors that the additional choices come with additional responsibilities. Unfortunately, individual investors often fall victim to the “behavior gap” due to mistakes related to emotional decision-making. Having discipline as an investor typically requires a focus on things within your control, such as asset allocation, contribution rates, minimizing costs, and asset location (i.e., pre-tax vs. Roth 401(k)).

Some Plan Sponsors Attach Additional Costs

Annual maintenance fees for using the mutual fund or brokerage window are common in retirement plans. It is also possible that costs associated with mutual funds available through the self-directed account may be higher than those in comparable funds within your plan's core menu. For these reasons, it is important to always check your plan’s fee disclosure to fully understand the actual costs related to your current 401(k), 403(b), or 457 plan. In fact, reviewing your investment portfolio fees should be part of every investor's annual financial check-up.

You Already Have Access to Investment Management 

An increasing number of retirement plan sponsors offer professional investment management. Target date retirement funds provide hands-off investing with professional management and asset allocation. These increasingly popular mutual funds provide instant diversification with portfolios to gradually become more conservative as investors approach their targeted retirement date. However, the self-directed brokerage can open this diversified fund alternative if your retirement plan does not provide access to target-date funds.

Self-Directed Brokerage Accounts Are Not Available for Everyone 

As previously mentioned, less than half of retirement plan sponsors actually offer a brokerage or mutual fund window for plan participants. Self-directed accounts are optional, and your employer's retirement plan administrator can decide whether they want to make them available to employees. 

Your investment performance should always be viewed in relation to your overall retirement planning strategy and life goals. That is why it is important to establish important benchmarks to track your performance. Pay attention to fees and growth when assessing self-directed retirement options, and review the funds' performance at least once a year.