EDITOR'S NOTE: This article was originally published in the March 2010 issue of Kiplinger's Retirement Report. To subscribe, click here.
The implosion of Enron employees' nest eggs may be fading from memory. But you don't need to remember 2001 to understand the risk of putting too many company-stock eggs in one 401(k) basket. How did your employer shares fare in the recent bear market?
Many people near retirement continue to place too much faith in their employer's prospects. In 2008, nearly one-third of workers in their sixties who were in 401(k) plans offering company stock had more than 20% of their account in employer stock, according to the Employee Benefit Research Institute. Of all the age groups, sixtysomethings represented the largest portion of workers -- at 8% -- holding more than 90% of their retirement assets in employer stock.
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Tying up a large amount of a portfolio in a single stock in a single industry increases the potential for volatility. People approaching retirement are especially vulnerable. A recent study by Financial Engines, an investment-management firm in Palo Alto, Cal., found that company stock contributed to increased portfolio risk for people in their late fifties and sixties.
"If the stock does poorly a year or two before you retire, that could have a serious impact on your retirement income," says Christopher Jones, chief investment officer with Financial Engines. "You don't have a lot of time to recover."
Some firms will not allow employees to purchase more employer stock once it reaches a certain percentage of their 401(k), such as 25%, says David Wray, president of the Profit Sharing/401(k) Council of America. To be on the safe side, it's best to limit your exposure to no more than 10% of your total investments.
Diversify Your Investment Basket
If you're concerned about the level of employer stock, consider selling some shares. Many companies match employee contributions in the form of company stock, and until recently, employees were stuck with it. However, the Pension Protection Act of 2006 required companies to allow employees with three or more years on the job to sell shares they obtained from employer matches.
Sell gradually, and then buy shares of mutual funds or other investments within your employer retirement plan. However, don't turn down a company match, even if it's company stock -- it's free money. Be sure to diversify your portfolio.
If you're about to retire and have employer stock that has appreciated significantly over the years, you could take advantage of a tax break called net unrealized appreciation, or NUA. When you take your assets out of the 401(k), you split the distribution. You would transfer the company shares directly into a taxable account and roll the rest into an IRA.
You will pay ordinary-income tax, of up to 35%, only on the original price the company paid for the stock. You will owe long-term capital-gains tax, of up to 15%, on the difference between the original price and any appreciation, but only when you sell shares. If you instead rolled the company stock into a traditional IRA, you would owe ordinary-income taxes on all appreciation when you made withdrawals.
Making use of the NUA break is often a good move, says Ronald Myers, a financial planner in Fort Lauderdale. But there are drawbacks. You're paying tax when you transfer the shares to the taxable account rather than waiting until you take traditional IRA withdrawals. Plus, he says, the capital-gains tax rate could increase.
Jones says workers should not hold on to their stock in order to wait for the NUA break. "You need to ask yourself: 'Is saving a little on taxes worth the risk of losing everything if the stock does poorly?' " he says.
If you're already retired, you may be overweighted in company shares that you rolled into an IRA or a taxable account. If you sell company shares from a taxable account, you will pay capital-gains tax on the appreciation. But if you hold on to the shares, you run the risk that a large portion of your portfolio will decline in value.
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