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We like to think that when we deposit a dollar at the bank, it goes into a big vault and we can pull out that same dollar at any time. But that¿s not how the U.S. banking system works. Banks take that money and invest it to make money themselves, so cash gets spread around. This, naturally, leads to a big risk: What happens if those investments go sour? Well, you¿d be out of luck. You can¿t get your dollar back.
The Federal Reserve doesn¿t like that scenario, so it prohibits banks from putting all the cash it has on deposit on the line. In fact, the Fed forces banks to keep a portion of their assets at the Federal Reserve itself, to make sure that some of your assets won¿t get squandered if the bank¿s bets go south. These are called ¿reserves,¿ (hence, Federal Reserve. Got it? Good), and usually amount to 10% of the total cash kept in checking accounts.
These reserves are never exactly 10%, and banks like to keep a little extra in reserve ¿ not, as you might think, to make you more comfortable that they¿re in good financial shape, but rather so they can take that excess and lend it to other banks and make money off it. (They¿re banks, they can¿t help themselves.) The rate at which they make these loans is called the Federal Funds rate, which is set by the Federal Reserve¿s Federal Open Market Committee.
When you hear people chattering about how the Fed cut or hiked interest rates, this is what they¿re talking about: the interest rate banks can charge for lending money from their reserves. This begs the question: If these are essentially loans between banks, why is the Fed Funds rate so important for the rest of the economy?
Well, simply put, because loans make the financial world go round. Bank A lends Bank B $10,000 at a Fed Funds rate of 5%. Bank B then lends out $10,000 to a small business at 7%. The small business then takes that money and expands the business and hires new workers. Now someone is employed, Bank B has made interest off the loan, and Bank A is the richer for making it all happen. It¿s perhaps overly simplistic, but you get the idea. When you want the economy to thrive, you make lending cheaper.
Of course, sometimes you don¿t want the economy to thrive. In fact, you might want it to cool down, mostly to avoid money flooding the system and causing inflation. In that case, the Fed raises interest rates, making it difficult to lend or borrow.
Home / Markets / Market Overview
Friday, September 02, 2005
Is My 401(k) Safe in a Bankruptcy?
Smart Money
My company is being liquidated. Does that mean my retirement fund is at risk?
Not to worry. Creditors may be flocking like vultures over the remains of your company's assets, but the vested portion of your account (i.e., the amount that you would be able to walk away with if you quit your job under normal circumstances) should be safe and sound. After all, that money belongs to you -; even if it's partially made up of funds contributed by your employer. And creditors can't get their sticky hands on those savings since all 401(k) monies are held in a trust at a designated financial institution (that is, a company other than your employer).
There are a couple of exceptions. First and foremost, if you're holding company stock within your 401(k) you could face trouble. When a company goes bankrupt, its stock generally gets crushed. And unfortunately, if your company match comes in this form, there may be little you can do to prevent this type of disaster. (This is part of the reason why we rarely recommend holding more than a small amount of company stock in your 401(k), if you have the choice.)
Secondly, many company managers have been known to illegally dip into a 401(k) or pension fund in times of trouble, says Ted Benna, president of 401(k) Assocation. If that were to happen in your case, it would be a matter for the courts. But rest assured that it's rare.
Another potential problem, says David Wray, president of the Profit Sharing/401(k) Council of America, is when a company declares bankruptcy during the time when your 401(k) contribution has been taken out of your paycheck, but has yet to be deposited to the trust. Contributions go through an administrative process, Wray explains, that can take anywhere from one day to a month, depending on the size of the company you work for. If your company files for Chapter 11 or Chapter 7 in the meantime, your contribution could get mired in the bankruptcy proceedings.
If your contribution is caught in limbo, there isn't much you can do except wait in line to collect what you're due. Luckily, employees have higher priority than most other creditors, so there's a good chance you can get that money, even if you'll have to wait awhile, says Wray.
But even though you can be confident about walking away with the vested portion of your portfolio, that doesn't mean you can rest easy. If your company is going through Chapter 7 bankruptcy and is liquidating all its assets, it's likely that your 401(k) plan will be terminated and you'll receive a lump-sum distribution, says Stuart Lewis, head of the pension group at Washington, D.C., law firm Silverstein and Mullens (a division of Buchanan Ingersoll). You'll then have to choose between rolling over your money into an IRA or a new employer's 401(k) (if you've got one), or taking your money in cash (which would mean you owe taxes plus a 10% penalty for an early withdrawal if you're under 59 1/2 years old).
Remember, too, that you have only 60 days to roll the money over into another tax-deferred account. Fortunately, your decision should be pretty simple: It almost always makes the most sense to roll the account over into an IRA. After all, your 401(k) probably had about 10 investment options, but with an IRA you've got thousands to choose from. For more on this, see our story "Rolling Over Retirement Accounts." And if you're over age 59 1/2 and want to take a lump-sum distribution (or if you're 55 or older and thinking about retiring), you'll want to read "How to Handle a Lump-Sum Distribution."
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