Can I Buy Stocks In My 401K

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 7 minute read

Employees can take advantage of tax breaks when purchasing shares of their company’s stock through a variety of stock option schemes. One of the best and most simple options is buying stock through their 401(k) accounts. However, this method is not without danger, which many employees are unaware of and may not discover about until it is too late.

History of Legislation

The Employee Retirement Income Security Act of 1974 paved the way for the development of 401(k) programs (ERISA). Retirement benefits for workers were the primary focus of this law. However, lobbying organizations on behalf of big firms have vowed to provide their employees with no retirement plan at all if they are unable to finance at least some of their retirement accounts with company shares. The legislative body in question, Congress, gave in.

Since then, businesses have used their own stock to finance these programs in a wide variety of methods and to varying degrees. Investing only in company stock is encouraged by certain firms, while others even match employee donations with stock. In certain organizations, employees can only get matching funds (or at least a bigger match) if they choose to invest in the company stock purchase plan.

Of course, after the downfall of Enron and Worldcom in 2002, regulators and the general public looked very closely at this behavior. In order to safeguard pensions for workers in the event of a business collapse, legislation like Sarbanes-Oxley and the Pension Protection Act of 2006 was enacted. Neither set of regulations, however, outright forbade the use of company stock in corporate retirement plans; rather, they just limited insider trading during a blackout period in the 401(k) plan while the plan administrator was being replaced.

There are a lot of knowledgeable people who think these actions aren’t enough. They think that legislation is needed to significantly limit qualified plan allocations of firm shares to no more than ten to twenty percent of plan assets.

The Benefits of Purchasing Company Stock in 401(k) Plans

Buying shares through a 401(k) plan offers the same advantages to the company as other employee stock purchase schemes. Among these advantages are:

  1. Employee Motivation and Retention Have Improved

Employees who are given the opportunity to buy business shares at a discount often report feeling more appreciated by their employer.

  1. Employers and employees can both make tax-deductible contributions.

The only other stock purchase plan where workers can make tax-deductible contributions to buy business shares is an employee stock ownership plan (ESOP). (Except in the case of a Roth 401(k), where the employee’s contributions are not tax-deductible but the payouts are tax-free.)

  1. Corporate Control

Employees who contribute to their 401(k) plans by purchasing business stock are able to exercise their voting rights notwithstanding the increased number of shares in circulation.

  1. Potentially Significant Gains

If the stock does well over time, an employee who invests in it will see their money rise much more quickly than if they had invested in a mutual fund.

  1. Capital Gains Taxation

According to the Net Unrealized Appreciation (NUA) regulations, employees who sell their shares of company stock are subject to the more favorable long-term capital gain rate for shares held for more than a year.

All payouts from traditional qualified retirement plans are treated as regular income, with the exception of the NUA provision. According to this regulation, the stock held inside the plan must be divested from the rest of the plan’s assets and sold in a single qualified transaction.

Employer stock in 401(k) plans has a number of Disadvantages

Despite the aforementioned benefits, most financial advisers caution clients against placing too much stock in their companies.

  1. Liquidity is low.

Employees who sell their shares before reaching age 59 1/2 will be subject to ordinary income tax and a 10% early withdrawal penalty if they put the money into a retirement plan. 

When compared to alternative stock plans, such as employee stock purchase plans or non-qualified stock options, the short-term advantage of buying shares through a retirement plan is less clear. Typically, participants in such programs get compensation or benefits in excess of their initial investments within a reasonable time frame.

  1. Purchases will not be discounted.

When stock is acquired through a 401(k) or other qualified plan, there is no exercise feature, in contrast to other forms of employee stock plans such as non-qualified or incentive stock options or employee stock purchase plans. As a result, there is nothing to negotiate with. 

When compared to the greater market price of the stock at the time of exercise, the bargain factor is the difference between the lower exercise price and the current market price. The difference between the two prices is pure profit for the worker with no risk involved.

  1. Employer Obligation

When encouraging their employees to invest in the company shares through their retirement plans, many companies overlook a crucial consideration. That means they have a duty as “fiduciaries” to their own plans.

The investment options they offer and the way the plan is funded and administered are subject to strict regulatory requirements for ethics and transparency. Regardless of the reason for a significant drop in their stock price, companies have a legal and moral obligation to their employees that might leave them on the losing end of a class-action lawsuit.

  1. Diversification is insufficient.

The aforementioned drawbacks are important considerations. However, over-concentration in a single position is by far the most significant problem employees confront when they acquire firm shares in retirement plans. This is especially true for workers who are taking part in their companies’ other stock purchase schemes, such an ESOP or ESPP.

Whether or not the asset was issued by the firm, employers and retirement plan administrators have a fiduciary duty to inform employees of the risks associated with investing too much money in a single stock or other instrument. When compared to mutual funds and other diversified investments, the value of an individual stock might drop much more precipitously and in a shorter amount of time.

  1. Worst-Case Situation

Jim and Mary have been married for a while now, and they both work for a firm that is listed on the stock market. Jim has put seventy-five percent of his retirement funds into company stock and bought one thousand shares through the employer’s employee stock purchase plan.

Mary has her retirement savings spread out among a number of mutual funds, each of which invests in a distinct set of asset classes and economic sectors. A spate of lawsuits filed against the corporation due to a defective product that caused or contributed to the deaths of multiple people came as a complete shock. All of Jim’s stock is rendered worthless as a result of the company’s bankruptcy. Mary’s retirement plan is the only significant asset the couple still owns.

Many specialists in the field of finance believe that employees should only be able to buy stock through non-retirement programs like ESPPs or stock options, while their retirement portfolios should be securely diversified over a suitable proportion of stocks, bonds, cash, and other alternatives.

They also recommend organizations take measures to improve employee education programs and cap stock purchases at 10% to 20% of the plan balance. For companies who don’t accomplish this, the SEC needs to implement penalties and other disciplinary measures.

Taking into Account the Risks

Workers should weigh the benefits and drawbacks of investing in company shares through their 401(k) or other profit-sharing plans before making a purchase. If their company went bankrupt, what would happen to their retirement savings? Having some shares in the firm might be beneficial in many cases. In many circumstances, it might also help to inspire the worker.

Those who want to invest heavily in their company’s stock, however, should do so outside of their 401(k) or similar retirement savings plan. If investors are concerned about holding onto their shares until retirement, participation in a non-qualified or incentive stock option plan or employee stock purchase plan may be a safer option.

Of course, employees also have the option of selling company stock inside the retirement plan, but doing so might result in a reduction in the amount of matching contributions they receive. Some companies will only match employee contributions if they are invested in company shares.

Complete Your Homework

Workers should do their homework on the firm and learn what the professionals have to say about the stock by obtaining analyst reports. If you have an online investing account with a firm like TD Ameritrade or E*TRADE, you may get these reports for free on the firm’s website.

Independent research firms like Morningstar provide a wealth of information dissecting your company’s financial records, performance, and trading history, both from a technical and fundamental perspective. Furthermore, if the company’s stock trades at a low price without any stock splits, this should serve as a strong warning indication to maintain the allocation of this stock within a portfolio to a minimum.

Bottom Line

Recent data reveals that even with the legislative steps discussed above, approximately 20% of all 401(k) assets are still invested in shares of their parent corporations. Employees lost billions of dollars in retirement savings when U.S. Airways and United Airlines went bankrupt.

However, despite a Vanguard report from 2012 showing that 401(k) plans are increasingly avoiding the usage of business shares, this trend is likely to persist, at least to some degree, for decades to come.

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