22 September 2021

Pros and Cons of 401(k) Brokerage Options

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Have you ever sat down in front of Netflix (ticker: NFLX), Prime Video or Disney+ and ended up surfing for 45 minutes while trying to decide what to watch? Then you just click on something to end your indecision. Maybe you'll land on a good show. Maybe not.

Investing can be a bit like that sometimes. Take your 401(k), for instance. It may have a "brokerage window," "brokerage option" or "self-directed 401(k)" option that allows you to buy a much broader range of investments than traditional 401(k) options that are often heavy on seemingly dull target-date funds.

The 401(k) brokerage account option can be tantalizing. For some, it may even be a good choice. But for most of us, all those decisions can end up being a detriment. You have to be careful, given that this is your nest egg.

What Is a 401(k) Brokerage Account? 

"The 401(k) brokerage option lets you treat your 401(k) like a typical brokerage account, which provides access to a much wider variety of investment options," says Wade Pfau, professor of retirement income at The American College of Financial Services. "Traditional 401(k) places typically only offer a limited selection of mutual fund choices."

These self-directed brokerage accounts permit plan participants to invest in publicly traded securities that aren't offered within the traditional investment menu provided by the plan sponsor, says Matthew Compton, director of retirement services with Brio Benefit Consulting.

"It is the individual's responsibility to ensure the investments they select are suitable for their financial situation including goals, time horizon and risk tolerance," says Brandon Tucker, manager of financial planning with eMoney Advisor.

And therein lies the double-edged sword that is the 401(k) brokerage option. "They can unlock interesting investment opportunities, but also come with heightened risk for investors," says Gaurav Sharma, CEO with Capitalize.

Potential Benefits of 401(k) Brokerage Accounts 

There's a reason investors may choose a 401(k) brokerage account. Several, actually:

You have the ability to choose from a wide range of investments that fit your situation. "Investors have more choices and can exert greater control over their portfolio, down to picking individual stocks," Sharma says. "More choice and control can be appealing to savvier investors."

You can trade actively while maintaining the tax advantages of a 401(k). For those interested in active trading, the brokerage option allows them to trade without worrying about the immediate tax impact, wash sale rules or the difference between short-term and long-term capital gains, Pfau says.

You don't have to go it alone; using an advisor is an option. "A lot of them can do the trading for you," says Tolen Teigen, chief investment officer with FinDec. "It's a way for a personal advisor to get in touch with your 401(k) and help with your trading."

Potential Risks of 401(k) Brokerage Accounts 

Of course, there's no such thing as a free lunch. These accounts have their drawbacks, too:

Without an advisor, you're much more exposed to risks. "If not professionally managed and done on your own, you run the risk of mismanaging the 401(k) assets and taking too much risk that the 401(k) plan line up is designed to help an employee mitigate," says Marianela Collado, CEO with Tobias Financial Advisors.

It can be a time suck. "Many people don't have the time or expertise to manage their own portfolio efficiently, which could lead to taking on more risk than appropriate with what is oftentimes an investor's largest investment account," Tucker says.

There may be higher costs. "Depending on the brokerage option, the platform can and may charge trading fees and higher expense ratios on mutual funds you buy from that versus those from the short list," Teigen says.

You may trade too often. "Long-term, buy-and-hold investing is generally a better approach for individual investors," Pfau says. "This is easier to accomplish when there are just a few options, which can then only be traded after the end of the business day."

There might be too many choices. "Investors potentially expose themselves to much greater risk when they have a wide range of investment choices that haven't been curated," Sharma says.

The Takeaway: Know Yourself 

If you like constantly educating yourself about individual securities and the wider market, and if you don't mind checking into your account more often or hiring and advisor to do that for you, then the brokerage option may be for you. At the end of the day, it's about knowing yourself and what kind of investor you are.

"We expect to see 401(k) brokerage accounts become significantly more popular in the years ahead as a result of the growing embrace of active trading by younger savers," Sharma says.

But if you'd rather set your retirement account and forget it, then you'll probably want to pass on the brokerage option. The same goes if you have a low risk tolerance.

"Those traditional options can seem far more boring at a time when stock market bullishness is high, but they typically come with far less volatility than bets on a meme stock or other individual investment picks," Sharma says.

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