Does company bankruptcy put 401(k) retirement fund at risk?

The big danger is investing too much in company stock

Question for the expert

Dear New Frugal You
I've been putting money into my 401(k) retirement plan for years, but my company and this economy have me scared. What happens if my employer goes out of business? Can the money that I put into my 401(k) plan be used to pay the company's debts? Could all my savings just disappear? -- Randy

Answer for the expert

Dear Randy,
Good questions! Like so many of us, you probably have much of your savings tied up in retirement accounts. According to the Center for Retirement Research at Boston College, the median amount in 401(k) retirement accounts was $56,000 at the end of 2008. Whether you've saved much above the average or you're just starting out, the thought of losing your savings isn't very comforting.

And, you're right. Many businesses are struggling in this economy. Some of them will declare bankruptcy and have their assets go to creditors.

But there's good news for you, Randy. Your 401(k) account cannot be taken to pay for company debts.

Why the confusion about 401(k) accounts? Because many people misunderstand how a 401(k) is structured. Fortunately, it's not as complicated as it may seem. We'll break it down into three easy pieces.

First, who owns your 401(k) plan? You do -- at least, any portion of it that's vested. Don't be afraid of that strange word. It just means that some portion of the account may have some strings attached.

Merriam-Webster defines "vested" as: "fully and unconditionally guaranteed as a legal right, benefit, or privilege (the vested benefits of the pension plan)."

Typically any money that you contribute yourself is fully vested from the moment you put it into the plan. Employer matching contributions, however, may have some vesting requirements. A common one is that an additional percentage of the company contribution is vested for every year that you work for the employer. The company's portion is not fully vested until the conditions are met.

So any money that you've contributed is fully yours. And any portion of the company's contributed that is vested also belongs to you. You own it.

The second easy piece is the plan administrator. The administrator oversees the plan for you. The administrator will:

  • Collect contributions from you and your employer.
  • Invest and distribute them per your instructions and the law.
  • Keep track of the funds and provide reports to you and, when appropriate, to the IRS.

Chances are that you'll never meet the administrator in person. You're much more likely to talk by phone or to use forms available in your human resources department to send instructions to them.

Again, they do not own your account. They just service it for you. For that service, periodically, they will deduct some fees.

The third piece is the investments within the account. The administrator will have a number of investment choices available for you. Typically, they'll include some safer options, such as bank certificates of deposit or U.S. Treasury bills. They will also include some things that are a little riskier, such as common stock and bond funds.

Many plans include the employer's common stock if it's publicly traded. Naturally, the company is happy to have employees invest in it. But that can be dangerous. Remember Enron? If the company struggles, not only could you lose your job, any shares in company stock could lose most, if not all, of their value.

And that is the biggest danger of a company bankruptcy to your account -- not that your account would be used to pay company debts, but that the company debts would severely reduce the value of any company stock in your account. 

What can you do to protect yourself? Generally, unless you really believe in your company's future, it's wise to limit how much company stock you have in your 401(k) account.

You may find that you own shares because of the company's contribution. Find out from the plan administrator when you're allowed to sell those shares and then do so, and reinvest the money in something else.

There is one other risk if your employer goes out of business. A bankrupt company could leave an "orphaned" plan. That's when the company and the administrator have abandoned the plan.

Without them, it's impossible for the employee to get at the money or change investment options. Obviously, that's not a good thing.

The U.S. Department of Labor has a fact sheet on abandoned plans. It will explain in detail what will happen if you find yourself with one, but the short answer is, a custodian will be appointed and the funds distributed to you, so you can reinvest it. The department also has a database of plans that can help you find if a particular plan is in the process of being terminated or has been terminated.

If your employer has declared bankruptcy, take immediate action. Contact the plan administrator. During the winding-down period that accompanies bankruptcies, the administrator may still be able to respond to your instructions. Once you get your money, reinvest it, either by putting it in an Individual Retirement Account or investing it in a new 401(k) with -- fingers crossed -- your new employer. The tax penalty for spending it is severe, so please avoid that if you can. 

So in short, if your company does declare bankruptcy, your 401(k) retirement savings could be in jeopardy, but not because of company creditors. Instead, the damage would come from the falling value of company stock and the inability to control your account and make necessary investment decisions.

See related: Ins and outs of borrowing from your 401(k), Save 401(k) hardship withdrawals for only the direst emergencies

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Updated: 12-15-2018