Danger: high levels of company stock

Owning your employer's shares in your 401(k) is a huge threat to your retirement. Keep it to a minimum.

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By Walter Updegrave, Money Magazine senior editor

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).
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NEW YORK (Money) -- Question: I'm 48 years old and have about 90% of my 401(k) invested in my company's stock and the rest in an international equity fund. I want to diversify further, but don't know where to turn. Any suggestions? --J.D., Glenville, New York

Answer: Diversify further? That's an understatement. You, my friend, need a total 401(k) portfolio makeover.

The glaring trouble spot, of course, is your huge concentration of company stock. Generally, I recommend that, to the extent you own your employer's stock at all in your 401(k), you limit it to 10% or so of your account's value.

If that percentage hits 20% of your 401(k)'s balance, it should raise a red flag. If your holdings reach 30%, a distress flare should go up. And if the percentage gets anywhere close to 90%, it should trigger an ear-splitting alarm: "Aaahhoooga, aaahhooga! Retirement security alert! Dangerous levels of company stock.!"

The problem is that once you get beyond a small holding of company stock -- or the shares of any one company for that matter -- you dramatically increase the riskiness of your portfolio in two ways.

First, you expose yourself to the possibility that your company may simply implode along the lines of Bear Stearns and Lehman Brothers, decimating the stock's value (and your 401(k)'s balance along with it) virtually overnight.

But even if that doesn't happen, there's another risk: heightened volatility. A single stock is typically two to three times more volatile than a diversified portfolio. And when you load up your 401(k) with the stock of one company, it subjects your account value to the possibility of much wider swings.

If you're lucky, that could mean much bigger returns than you would get with a more balanced portfolio. If you're unlucky, though, it could mean truly abysmal performance. But on average the higher the concentration of a single stock you own, the lower your expected return -- and the smaller your nest egg is likely to be.

In short, the payoff you'll likely get from investing in company stock doesn't adequately compensate you for the risk you're taking.

Fortunately, the level of employer shares in 401(k)s is on the wane. In 1999, two years before Enron employees who held Enron stock lost all or most of their retirement savings, company stock averaged about 36% of 401(k) account balances at companies that offered employer shares as an option. An EBRI-ICI report on 401(k) allocations released in December put that percentage at 20.5%.

That's a definite improvement, but there are still holdouts. The report shows that nearly a quarter of 401(k) owners in plans that offer company shares have more than 30% of their account in employer stock and that roughly 15% have more than half their balance riding on company shares.

Get help diversifying

So, about that further diversification. Basically, you need to rebuild your portfolio from the ground up so that you not only own a broad range of stocks, but bonds as well.

There are a few ways you can do this. One is to go to our Fix Your Mix tool. You can then take that recommended mix and plug it into the T. Rowe Price Asset Allocator tool, which will give you an estimate of how It might perform.

Or you can go to a calculator like Fidelity's myPlan Retirement Quick Check, and get an estimate of how large a nest egg you might have at retirement and how much income it might generate.

Either way, with a little bit of experimenting and trying different mixes of stocks and bonds, you should be able to come up with a 401(k) portfolio that is light years ahead of the one you now have.

As for which investments you should choose from your 401(k)'s lineup, I'd recommend sticking as much as possible to low-cost funds and particularly index funds to the extent they're available.

If you're not jiggy with the prospect of revving up online calculators or choosing funds, see if your 401(k) plan offers a managed account option or some other form of advice. If not, you can always consult a financial planner.

You should have no problem reducing your holdings of company shares. You're always allowed to switch out of any shares that you bought on your own or that you voluntarily bought using company matching funds. If your company required you to take your match in company stock, it can restrict your ability to move out of those shares, although 2006's Pension Protection Act allows you to switch out of such shares after three years of service.

Get a tax break

I think everyone should avoid accumulating a large position of company stock within a 401(k). That said, if you already have a large position that you've built over the years and that contains shares selling for a much higher price than you paid for them, consider taking advantage of the net unrealized appreciation, or NUA, strategy.

Basically, this strategy involves taking a lump-sum distribution of all the assets in your 401(k). You take the company stock "in kind" -- that is, you take actual shares -- and you roll the remaining money into an IRA or other retirement plan. The advantage to taking the actual shares is that you pay income tax at ordinary rates on the basis only -- that is, the price you paid for the shares. You then pay tax at long-term capital gains rates on the difference between your basis and the sales price when you later sell those shares. That can result in a big tax savings if your company's stock has appreciated strongly over the years.

To take advantage of this tax break, you must be eligible for a distribution from your 401(k), which typically means you must either be switching jobs or retiring. Even if that's the case, however, this is a strategy you should approach with caution.

If you're switching jobs and are under age 55, you would owe a 10% early withdrawal penalty on any 401(k) distribution you don't roll over into an IRA or other eligible retirement plan. That could seriously erode the benefits of the strategy.

And the fact that you may qualify for a tax benefit does nothing to reduce the investing risk you're taking by holding a large position in a single stock. If the value of your company shares plummets, the tax savings and your 401(k) balance would shrink simultaneously. So you don't want to let the potential tax savings blind you to the risk of owning company shares.

Aside from that possible tax wrinkle, though, I recommend you limit your holdings of company stock to no more than 10% of your portfolio. Or better yet, cut it to zero. There are already enough threats out there to your retirement security. Why add company stock to the list? To top of page

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