Sometimes buying what you know is a smart investment strategy — and sometimes it’s not.
If you work for a publicly traded corporation, the list of investment choices in your 401(k) plan may include the opportunity to buy company stock or put money into a company stock fund.
You may even find there are incentives to encourage you to make this choice. For example, you may be able to purchase the stock at a price that’s lower than the current market price. Or, you may be able to put in a higher percentage of your pay if you choose company stock. And, in certain instances, the amount you choose to invest in company stock can determine the percentage of the match you receive.
In fact, some employers make their entire matching contribution in the form of stock instead of cash. If that’s the case, your account is credited with company stock or shares in a company stock fund, no matter how your individual contributions are invested.
When you invest your 401(k) in company stock, you may get…
|Better 401(k) matching||Restrictions on when you can sell||Tax advantages||Dropping price on stock|
Pros and cons of company stock investments
When you receive matching contributions in the form of company stock, an increasingly large percentage of your total portfolio may be in a single investment. In fact, in some plans where this matching arrangement is in place, employees may have up to 50% or more of their portfolios allocated to employer’s stock.
Many retirement experts argue that diversification is a critical component in your retirement portfolio, and that you can’t afford to take the risk of overemphasizing any investment, even one that may provide a significant return. Their advice is a maximum of 10% to 20% in company stock.
There may be good reasons to invest in your company’s stock. After all, you probably understand the products and services, what the company’s doing to expand its business opportunities and market share, and the strengths or weaknesses of its management. Those are exactly the kinds of things you investigate when you’re considering any stock investment. And investing in your employer’s stock gives you an opportunity to share in the success you’re contributing to as an employee.
But there are risks. You already depend on your employer for your current income. If you have a defined benefit retirement plan in addition to your 401(k), the company will also be providing part of your retirement income. So you might want to think twice about tying your financial security too tightly to a single source.
In the worst possible circumstance, if your employer went out of business, you might not only be out of a job, but the portion of your 401(k) that’s invested in company stock might be worthless. Company bankruptcies and stock price collapses, as recent history shows, can and do happen, leaving employees without assets.
Some tax advantages
If company stock increases in value before you’re ready to retire — as you hope it will — you may be able to postpone paying tax on the gain by withdrawing the stock from the plan rather than moving it to a rollover IRA with other plan assets.
If you take the stock out, you owe income tax on only its value when it was added to your account, not on any increase in value. You owe no additional tax as long as you hold onto the stock.
And, when you do sell, you may be eligible to pay tax on any increase in value at the long-term capital gains rate. In fact, selling company stock is the only current exception to the rule that all withdrawals from retirement plans are taxed at your regular income tax rate. But the rules are tricky, so be sure you get expert professional advice.
Employer stock ownership plan
Choosing to buy company stock with your 401(k) contributions is different from getting stock from your employer through an employer stock ownership plan (ESOP). An ESOP, when it has been approved as a retirement plan by the IRS, is a trust to which the company contributes shares of newly issued stock, shares the company has held in reserve, or the cash to buy stock. The shares go into individual accounts set up for employees who meet the plan’s eligibility requirements —generally the same ones that determine eligibility for a 401(k).
In fact, while an ESOP may be separate from a 401(k), it may also be part of the same plan. If it’s linked, your employer may match your contribution by adding shares to your ESOP account rather than adding cash to your investment account. In many cases, matches made through ESOPs are more generous, in part because there are tax advantages to using an ESOP and in part because offering an ESOP can be a good way to attract interest in — and contributions to — the retirement plan.
If you leave your job, you have the right to sell your shares, on the open market if your employer is a public company or back to the ESOP at fair market value if it’s not. About 90% of companies offering ESOPs are privately held.
The Truth About Company Stock Investments In Your 401k Plan by Inna Rosputnia
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