Yes or no: Have you ever chatted about your retirement savings plan at a cocktail party? If yes, you're probably among the country's elite, long-term savers. You might enjoy reading a good fund prospectus, debating appropriate asset allocations for any age, or sharing feedback and requests with your 401(k) plan administrator. It's also possible you've outgrown the limitations of your standard 401(k), and you're ready to move into a self-directed plan.
The self-directed 401(k) usually takes the form of a brokerage account inside your standard 401(k). You might see it referred to as a brokerage window or self-directed brokerage account (SDBA). If your employer offers self-directed retirement investing, you'd have access to a bigger list of mutual funds or even the full range of stocks, bonds, and exchange-traded funds. Your employer sets the rules, but the selection should be much broader than the 10 or 20 funds available in your traditional 401(k).
More choice for your retirement savings might sound like a breath of fresh air, but it also introduces more risk and, possibly, higher fees. Those trade-offs are worth it if you can achieve higher performance by investing outside the standard 401(k) fund menu. Here are three signs you're ready to take that leap.
1. You are an experienced investor
401(k) plan fiduciaries are obligated to set up the plan in a way that best serves its participants. Most 401(k) savers are not expert investors. Just the opposite -- they're more likely to have no background in investing. A digestible menu of investment choices works for these novices, because they're not as familiar with best practices for risk management and asset allocation.
If you've done a fair amount of investing outside your 401(k), you've already proven yourself to be comfortable with a large universe of investment options. You have a plan with objectives, and you follow a process. You understand how to manage your own risk. You've made investing mistakes, but you've been successful, too. And most importantly, you know how you'd invest your 401(k) funds if you had more options.
2. You are frustrated with the quality of funds
One of the more common complaints among savvy investors is that the standard 401(k) funds are not high quality. They may have high expense ratios or simply be the products of a lesser-known fund family. If you've ever projected your cumulative spend on mutual fund fees over the next 30 years or complained to your plan administrator about the fund selection, you're probably ready for self-directed investing.
3. You've outgrown your IRA, too
A traditional or Roth IRA doesn't limit you to a handpicked set of mutual funds; you can invest across the exchange-traded universe of stocks, bonds, and funds. You could therefore use your IRA to hold more sophisticated positions that would complement the standard offerings in your 401(k) -- that's assuming you need to invest something in your 401(k) to max out your employer. If you don't have employer match, you could house your entire retirement portfolio within your IRA. That way, you'd bypass all of the restrictions in your standard 401(k).
The big drawback of that strategy is that IRAs have much lower annual contribution limits than 401(k)s. In 2021, you can defer up to $19,500 of your paycheck into your 401(k), plus another $6,500 in catch-up contributions if you're 50 or older. The annual contribution limit for IRAs is a meager $6,000, or $7,000 if you're 50 or older.
Note that if you are also putting money in your 401(k), your traditional IRA contribution may not be tax-deductible -- though your earnings in that account will still be tax-deferred. For your retirement contributions to be fully tax-deductible or to invest more than $6,000 annually in positions that aren't available in your 401(k), you'd need the self-directed plan.
Before you break out on your own
The biggest downside of the self-directed 401(k) is the extra risk involved in having more investment choices. Even if your natural investing style is aggressive, it's not appropriate to bet big with your retirement funds. Before you move into a self-directed plan, set out some parameters for yourself in terms of asset allocations and the qualities that make a position investable for you.
It's easy to let your confidence trick you into skipping this step, but it's an important exercise. If you don't know where to begin in defining your plan, for example, that may be a sign to hold off. On the other hand, if you could write a book on the details of your retirement investment plan, that confirms you're probably ready to graduate to a self-directed 401(k).