401(k)s and Employer Stock: Great Opportunity or Big Mistake?

Don't make a decision you'll regret. Image source: LaurMG via Wikimedia Commons.

Many people think of saving for retirement as being somehow different from regular investing, and in some ways, they're right. Retirement saving involves special account types like 401(k)s and IRAs, and tax incentives play a major role. Yet underlying all those specialized factors, you'll still find simple basics of investing, and one of the most important is to avoid taking on excessive risk.

Some 401(k) plans give workers the opportunity to invest in shares of their employer. Although the trend has moved away from employer stock in recent years, Fidelity recently found that, among its customer base, 15 million people owned company stock worth about $400 billion as of mid-2015. As a result, many workers still need to know how to evaluate whether taking advantage of that option is a smart move.

Let's take a closer look at employer stock in 401(k) plans with the goal of figuring out whether it serves a valid place in your retirement investing.

The argument against employer stock in 401(k) plansThe most convincing argument against investing your 401(k) in employer stock is that it concentrates your financial risk to an extremely high extent. For most people, their jobs are their biggest source of income, with future earnings potential dwarfing saved assets until relatively late in their careers. The loss of a job can be devastating, putting some people into immediate financial difficulty, and putting pressure even on those who are prepared for unforeseen emergencies.

By investing in employer stock, you add even more risk that's tied to your employer's success. As workers have seen countless times at companies like Enron, Bear Stearns, and other failed enterprises, when a company faces difficult business conditions, its stock often takes a hit, and its response is often to start laying off personnel.

If your employer falls on tough times, then you could easily see not only the value of employer stock you own in your 401(k) plunge, but also your annual income jeopardized by a layoff or involuntary work reduction. That potential double-whammy is enough to convince many people never to own employer stock in their 401(k) plans.

Indeed, employers themselves have found out the hard way that offering their own stock in 401(k) plans can get them into legal trouble. As fiduciaries for their plans, employers have to be prudent in selecting investments, and workers routinely file lawsuits when an employer's stock drops, alleging a breach of fiduciary duty, and seeking to have the company make battered 401(k) account balances whole. These lawsuits have met with mixed success, but many employers have nevertheless concluded that it's best to protect workers from themselves, and either impose strict limits on company stock, or just take it out of 401(k) plan options entirely.

When employer stock makes senseDespite the arguments against employer stock in a 401(k), smart investors know that there are always exceptions to the rule. In a couple of instances, keeping some employer stock in your retirement plan account can make sense.

First, some employers offer their shares to plan participants at a discount to fair market value. This makes those shares a much more compelling investment opportunity, especially if the requirements for how long you have to hold the stock aren't all that restrictive. Under those circumstances, considering employer stock makes more sense, although buying it in moderation is still smart if your 401(k) assets make up the bulk of your overall savings for retirement.

The other advantage of owning employer stock comes when it's time to take distributions from your 401(k). Under the net unrealized appreciation rules, you can take a distribution of employer stock in kind and deposit shares into a regular taxable brokerage account. You'll pay income tax on the original cost of those shares when you bought them in your 401(k), but any gain since then will be deferred until you actually sell the stock.

Furthermore, the gains on the stock qualify for long-term capital gains treatment, which is much more advantageous than the ordinary income-tax rates that usually apply to retirement-plan distributions. The combination of these favorable factors makes company stock worth considering if you expect long-term gains.

Despite these advantages, holding employer stock in your 401(k) is a risky proposition. Even though it can seem like a no-brainer to invest in a company you respect enough to be a part of, the concentration of financial risk makes doing so more dangerous than it's worth in most situations.

The article 401(k)s and Employer Stock: Great Opportunity or Big Mistake? originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.