401(k) risk: Money in limbo due to employer bankruptcy

Retirement dough can be tied up or you could be hit with high fees

By Gary Foreman

The New Frugal You

Gary Foreman is a former financial planner who currently edits The Dollar Stretcher website and newsletters. He writes "New Frugal You," a weekly Q&A column about frugal living, for CreditCards.com Ask a question. 'New Frugal You' archive

Dear New Frugal You,
I've read about this case where a 401(k) wasn't safe. Seems like the employer went out of business and now people can't get their money out. What about me? Is mine safe? I'm depending on my 401(k) for my retirement. Is that a mistake? -- David

Dear David,
You're right to be concerned about the safety of your 401(k) plan. For many of us, our 401(k) plan is intended to be a major source of retirement income. It's important to protect that asset. So let's take a look at what dangers there could be to your 401(k).

How 401(k) plans work
To begin, let's review how a 401(k) plan works. They were created by The Revenue Act of 1978. An employer must set up the plan. They will choose an administrator to handle the operation of the plan. The administrator is responsible for protecting your money and investing it per the law and the plan agreements.

You can contribute a portion of your salary to the plan on a pretax basis. Anything you contribute is not counted as current income for this year's federal income taxes.

While the money stays in the plan any earnings are not taxable. You'll be taxed when you take the money out of the plan.

Your employer may choose to match some or all of your contributions. They're allowed to put some restrictions on the money they contribute. A common restriction is to impose a "vesting period." It requires the employee to stay with the company for a certain period before the employee gains the right to fully own the company's contribution. When the requirement is met, the money is said to be vested.

The administrator will offer you a variety of investment options. They'll have control over which ones are made available. Common choices are stocks, bonds, mutual funds, CDs and money funds.

Some plans also allow you to borrow money from your 401(k). In that case, you're required to pay the loan back just like any other.

Risks of 401(k)s
Now that we've looked at how the plan works, let's see where the dangers lie.

There are two potential sources of risk in your 401(k) plan:

• The risk that the assets that you're invested in lose value.
• The risk that bankruptcy or theft takes the money from you.

The first risk was demonstrated at the beginning of the 2008 recession. Many stock investors saw their account balance plummet as the market tanked.

The risk is exactly the same as it would be with an investment outside a 401(k). Some investments are safer, but pay less. Others have more potential, but carry greater risks. Bottom line? No investment is more or less safe simply because it's in a 401(k).

The second risk, an employer's bankruptcy or theft, is probably scarier but much less likely to affect your money. Part of the reason it's more frightening is that we don't understand what happens to a 401(k) when the sponsoring business goes through a bankruptcy.

Your company can go bankrupt, but none of the people it owes money to have access to your 401(k) assets. You are not liable for company debts and your 401(k) cannot be used to pay them.

If the employer goes bankrupt and liquidates, the 401(k) plan will be terminated (as will your job). The company is supposed to promptly turn control of the money over to a trustee. All terminated employees will have the opportunity to take their money or roll it over into another approved retirement plan, and it's supposed to take place in no more than a year.

Take that opportunity so that you have greater control over your retirement savings. Rolling it into a self-directed individual retirement account will allow you to select plan sponsors and have the widest possible choice of investment options.

Because your employment was terminated, you'll will lose any unvested portion of the employer's contribution -- the same as if you had left the company for another job.

You'll get all of your contribution. Any investment gains or losses will affect how much your contribution is worth at that time.

You probably also face some risk if you have company stock in your 401(k). Many companies contribute company shares as part or all of their contribution. Often they restrict your ability to sell those shares within the plan.

Naturally, stock in a bankrupt company isn't worth much. Anyone reading this should avoid this problem by never overloading a 401(k) with any one company's shares. No matter how much you believe in your employer, spread your risk and periodically sell off company shares. Ask any former Enron employee whether they wished they had sold their company shares as soon as they could.

And finally, as with the case you cite, it's also possible for the administrator to go bankrupt, or for the trustee to drag its feet. Again, your 401(k) money cannot be used to pay their debts.

The trouble comes in while your money is in limbo. It's a big deal for older account holders: Those near the required minimum distribution age of 71-1/2 must make minimum withdrawals yearly, and face big penalties from the Internal Revenue Service if they fail to do so.

In addition, your fees could skyrocket under the new administration. In the case you cite, one former employee got hit with administrative fees of $24,000 for one year.

David, you're right to be concerned about your 401(k) retirement plan. And while your biggest risk is still from the investment choices you make, you've put your finger on another rare, but significant one.

This would be a good time to check up on the health of your employer, and to keep an eye on it.

See related: Be wary of 401(k) loans, Don't use 401(k) savings to pay off card debt

For more than 35 years, Gary Foreman has worked to help people get the most for their money. Prior to founding The Dollar Stretcher.com, he was a financial planner and purchasing manager. Gary began The Dollar Stretcher website and newsletters in April 1996. Today the website features more than 6,000 articles on different ways to live better for less. Gary has been interviewed by The Wall Street Journal, The Nightly Business Report, USA Today, Reader's Digest and other newspapers and magazines. Gary answers a question about a budgeting or saving issue from a CreditCards.com reader each week. Send your question to The New Frugal You.

Published: September 13, 2012

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