The Growing Popularity of 401(k) Self-Directed Brokerage Accounts

Charlene Rhinehart, CPA and CFE, chairs an Illinois CPA Society committee and holds a degree in accounting and finance from DePaul University.

Traditionally, employer-sponsored 401(k) plans limited investment options to mutual funds, annuities, guaranteed accounts, and sometimes company stock. However, a growing number of plans now offer participants the ability to trade individual securities within their 401(k) through self-directed brokerage accounts (SDBAs), also known as 401(k) brokerage windows.

This innovative option introduces a higher level of investment control but also increases risk exposure, prompting careful consideration from fiduciaries and investors alike. Those with access to SDBAs must weigh potential rewards against the risks inherent in active trading.

Key Insights

• Self-directed brokerage accounts expand investment possibilities far beyond conventional 401(k) options.
• Transaction fees associated with frequent trading can reduce overall returns.
• Conservative allocation strategies often lead to better long-term outcomes.

Understanding How 401(k) Self-Directed Brokerage Accounts Operate

Employers offering SDBAs partner with brokerage firms like E*TRADE or Charles Schwab, integrating these accounts alongside standard plan choices. Participants may be allowed to transfer funds between their main 401(k) account and the brokerage window during designated periods.

Within these accounts, investors can buy and sell stocks, bonds, ETFs, and mutual funds without immediate tax consequences. However, certain high-risk activities, such as margin trading and options or futures contracts, are typically prohibited, although covered call writing might be permitted unless restricted by the plan.

According to a 2023 Plan Sponsor Council of America survey, 38.8% of plans provide brokerage windows.

Quick Fact

Vanguard’s 2024 How America Saves report reveals that while 21% of its 401(k) plans include brokerage windows, only about 1% of participants utilize them.

Pros and Cons of 401(k) Self-Directed Brokerage Accounts

Utilizing an SDBA presents both opportunities and challenges.

Advantages

• Access to a broader spectrum of investments, including individual stocks, ETFs, and bonds.
• Ability to diversify across various market sectors and niches.
• Potential for higher returns for knowledgeable investors compared to traditional plan options.

Disadvantages

• Inexperienced investors risk significant losses through poor trading decisions.
• Constructing a balanced portfolio is more complex, especially when factoring in transaction costs.
• Emotional decision-making can lead to detrimental buying and selling patterns.

Greater Investment Choice

SDBAs empower participants to tailor their portfolios with precision, targeting specific sectors or emerging markets that conventional 401(k) offerings may not cover. This flexibility can accelerate portfolio growth for savvy investors.

Risks for Novices

However, this freedom can be a double-edged sword. Since 401(k) plans must be nondiscriminatory, all employees—including those with limited investment knowledge—gain access. Often, these features were introduced at the behest of senior employees who benefit from professional advice, leaving others potentially vulnerable.

David Wray, president of the Plan Sponsor Council of America, notes that brokerage windows are typically favored by highly compensated employees rather than the average 401(k) participant.

Essential Note

Successfully managing an SDBA demands substantial expertise and disciplined investment strategies.

Who Benefits and Who Risks Losing with 401(k) Brokerage Accounts?

Experienced investors with strong market knowledge can leverage SDBAs to achieve superior returns compared to traditional mutual fund options. Conversely, less informed employees may fall prey to costly mistakes, such as selecting funds with high fees or misunderstanding risk levels.

Data from Vanguard, Fidelity, and Schwab consistently show that only a small fraction of eligible participants actively engage with brokerage windows.

Average Balances in Self-Directed Brokerage Accounts

Charles Schwab reports that as of Q2 2024, the average advised balance in SDBAs was $335,008, indicating that active users tend to hold substantial assets in these accounts.

Challenges of Self-Directed Brokerage Accounts

The expansive investment choices can complicate portfolio construction, and frequent trading fees may erode gains. Without a clear investment plan, emotional decisions can lead to chasing trends and poor timing.

Fiduciary Considerations for Plan Sponsors

Plan sponsors must carefully evaluate potential liabilities related to losses incurred by inexperienced investors using SDBAs. While many believe they are shielded from responsibility, some legal experts advise caution. Unlike other plan investments governed by ERISA fiduciary standards, SDBAs introduce unique oversight challenges.

Final Thoughts

For knowledgeable investors, 401(k) self-directed brokerage accounts offer exciting opportunities to diversify and potentially enhance retirement savings. However, less experienced employees should approach these accounts with caution and consider limiting their exposure. Monitoring fees and maintaining a disciplined strategy are crucial for success.

A prudent approach involves allocating the majority of retirement assets to traditional plan options while using brokerage windows sparingly. For personalized guidance, participants should consult their plan sponsors or financial advisors.

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