One of the biggest disadvantages of 401(k)s is that you're usually limited to a few investment options that have been selected by your employer and may or may not fit your needs. Historically, most workers had no other choice if they wanted to contribute to their 401(k)s, but the rising popularity of 401(k) self-directed brokerage accounts is changing this.
More options aren't always better, though, especially if you're new to investing and are unsure what to choose. Below, I explain 401(k) brokerage accounts in more detail, along with who may want to consider them and who is better off staying away.
What is a 401(k) brokerage account?
A 401(k) self-directed brokerage account, also known as a 401(k) brokerage window, is an alternative to the traditional mutual funds -- collections of stocks and bonds -- and annuities, which are contracts with insurance companies, commonly available through 401(k)s. Your employer picks a brokerage firm to work with, and you create an account with the firm and invest your retirement savings in mutual funds, individual stocks and bonds, exchange-traded funds (ETFs), and more -- with all the tax advantages of a traditional 401(k). However, options trading and borrowing on margin are not allowed through these accounts.
Brokerage accounts used to be limited to 401(k) plans for professionals, like doctors and lawyers, but 40% of all 401(k)s now offer them, according to a 2015 study by Aon Hewitt. Whether a brokerage account is the right choice for you depends on whether you have the skills to manage it properly.
Pros and cons
The obvious advantage of a 401(k) self-directed brokerage account is that you can choose from a wider range of investments. If you know how to invest that money wisely -- or you can afford to pay someone who does -- a 401(k) brokerage account can be a smart decision. It may enable you to grow your retirement savings more quickly than you could if you were limited to a few investment products chosen by your employer.
But if you don't know much about investing, this apparent advantage could end up costing you. You may not diversify your investments enough or could end up making emotional decisions, like selling a stock that has been doing poorly lately even though it has historically done well. This could hamper the growth of your retirement savings.
You also have to watch the cost. The brokerage firm may charge you fees for its services, and the investments you choose may come with their own fees, like the expense ratios on mutual funds. These can eat into your profits and may leave you worse off than you would have been if you'd stuck with the mutual funds offered through your employer.
Things to know before opening a 401(k) brokerage account
If you're considering a 401(k) brokerage account, the first thing you must decide is what percentage of your retirement savings you'd like to put there. You can put all of it there if you'd like, but it may be better to leave part of it in a mutual fund chosen by your employer, just to be safe.
You should also note that some 401(k)s only allow you to transfer funds to a brokerage account during a certain window each year. If this is the case for your plan, make a note of this time frame so you don't miss it.
Next, look into the account maintenance fees and any other fees associated with the investment products you're considering. Ideally, you can keep these at or below 1% of your assets. That means you'll pay $1,000 or less per year for every $100,000 you have in the account. If you plan to employ a financial adviser to help manage or offer suggestions for your 401(k) brokerage account, don't forget to factor in those fees as well.
If a 401(k) brokerage account isn't a good fit for you, go with one of your employer's investment selections instead. This is the safer bet if you don't have the time or interest to learn more about investing. These are your retirement savings at stake, so you don't want to take unnecessary risks.