401(k) plans are undeniably useful in helping you save for retirement. If you had to name the most annoying thing about 401(k) plans, though, many participants would say that the limited investment options available in most plans represent the biggest hurdle in trying to accomplish their financial goals. Especially for those who have taken the time to educate themselves on individual stocks, being forced to use broad-based mutual funds or exchange-traded funds puts a damper on their ability to generate the returns that they want.
Even though most employers stick with a restricted menu of investments in their 401(k) plans, there's no rule within the laws and regulations governing 401(k)s that requires them to do so. In response to the wishes of their employees, some employers have opened up their investing options by including a self-directed brokerage option. Doing so can solve a big problem for participants, but you should also make sure you understand both the risks and the potential rewards of a self-directed 401(k) brokerage option before you start taking matters into your own hands.
How a self-directed 401(k) brokerage option works
The mechanism by which your employer makes the self-directed option available to you is relatively simple. Typically, most employers work with outside financial firms to manage their 401(k) plans, and increasingly, many of the more commonly used financial companies for 401(k) administration have discount brokerage arms affiliated with their business. As a result, those firms can offer plan participants access to discount brokerage services if the employer chooses to allow it.
One thing to bear in mind, though, is that with the self-directed brokerage option come potential added costs. In most cases, the financial company that's helping to administer the 401(k) plan will charge commissions for buying and selling stocks and other investments through the plan. You should look closely at the fee schedule that applies to your plan, as it won't always match up perfectly with the costs that the same firm charges to ordinary brokerage customers with a regular non-401(k) account.
Should you use the brokerage option in your 401(k)?
Even with commission costs, you might well find that the amount you pay in investing costs is less if you follow a long-term buy-and-hold investing strategy for your stock portfolio. The mutual funds you'll find in most 401(k)s have costs of their own, and with annual expense ratios that can exceed 1%, the amount of money that gets siphoned away in fees will grow along with your account balance. By the time you have $50,000 in your 401(k) account, a 1% expense ratio means you're paying $500 in investing fees. That amount would pay for many trade commissions at most brokers.
The challenge of the brokerage option, though, is that investing small amounts can be more costly than it's worth. If you save $100 a week in your 401(k) plan and have four stocks you like to invest in, then the commission cost of repeated $25 purchase transactions will be prohibitively expensive.
The better solution for those whose 401(k) brokerage option charges commissions is to allow money to accumulate in your account, either in a cash option or in a stock-index mutual fund to give you exposure to the broader market's performance. Once your available cash for investing reaches a certain level, then you can transfer money into the brokerage option and make larger stock purchases.
Can you handle a self-directed 401(k)?
The other major question you should ask in considering a self-directed 401(k) brokerage option is whether you have the experience and confidence to manage your own retirement money in a way that concentrates your risk in just a few different stocks or other investments. Using mutual funds is no guarantee of success, but they give you diversified exposure to asset classes that can reduce your overall risk somewhat. Your 401(k) retirement money isn't something you should be taking huge amounts of risk with unless you know exactly what you're doing.
Nevertheless, as long as you're smart about investing within your abilities, a self-directed brokerage option can free you up to invest all or a portion of your money in investments with a higher probability of producing outstanding returns over time. Self-directed 401(k)s aren't for everyone, but if you have what it takes, you should consider taking advantage of a brokerage option if your 401(k) plan offers it.
Dan Caplinger 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.