Trading Options for Your 401(k)

While most IRA providers allow you to invest in a broad universe of mutual funds, exchange-traded funds and individual stocks, the rules for 401(k)s and other employer-provided retirement plans are typically more restrictive. Most offer a limited menu of mutual funds from which to choose, including target-date funds, which are one-stop portfolios of stocks, bonds and other assets that gradually become more conservative as you near retirement.

Many employees are just fine with a limited selection. Studies have shown that offering workers too many options reduces participation rates. Faced with too many choices, some workers simply throw up their hands and walk away. In addition, employers are required by law to act in the interest of plan participants, which makes them reluctant to offer untested or risky investment choices.

The self-directed brokerage option. But what if you’re interested in taking a little more risk in exchange for potentially higher returns? About 40% of companies offer self-directed brokerage accounts in their 401(k) plans, which allow participants to invest in a much broader menu of mutual funds, ETFs and, in some cases, individual stocks. A small 401(k) provider, ForUSAll, is even allowing its participants to invest up to 5% of their account balance in cryptocurrency.

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Historically, only a small percentage of savers have enrolled in self-directed brokerage accounts, but that could be changing. The Thrift Savings Plan, the federal government’s version of a 401(k) plan, recently announced that it will offer its 6 million participants the ability to invest in more than 5,000 mutual funds through a new self-directed brokerage account. This is a major change for the federal plan, which previously limited its lineup to a menu of low-cost index funds.

The TSP board said its decision to offer the brokerage account, which will be available in mid 2022, was driven by demand from investors for more choices, particularly when it comes to funds that pick securities based on environmental, social and governance criteria (see Introducing the Kiplinger ESG 20). As demand for ESG funds grows, look for more 401(k) plans to add these options to their main menus or self-directed brokerage windows.

As is the case with your IRA, you can trade stocks and funds in your 401(k) without reporting your gains and losses to the IRS when you file your tax return. Taxes are deferred until you take withdrawals; in the case of a Roth 401(k), your profits are tax-free as long as you’ve owned the account for at least five years and you’re 59½ or older when you take the money out.

If you’re interested in adding some spice to your 401(k) plan, though, you’ll probably have to pay for the privilege. You may have to pay an annual maintenance fee, plus transaction fees if you use the account to trade stocks or funds. You may also pay a higher expense ratio for the funds you buy through the brokerage window than you’ll pay for the funds in your plan’s regular lineup.