Every year, an estimated 470,000 U.S. businesses close their doors for good. Employees (and their employers) who go through this experience have are left with several balls to juggle, including how to secure health coverage, meet their list of upcoming bills, and start the search for a new job. To help you through these tough times (or just to be ready if it were to ever happen to you!), let’s review what to expect with your contributions when a company goes out of business and what your options are.
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Are your 401(k) funds safe if the company is dissolved or bankrupt?
Let’s start with some good news: yes, the bulk of your 401(k) money is safe. The Employee Retirement Income Security Act (ERISA) protects the majority of your 401(k) contributions by requiring your employer to hold plan assets in a trust account, apart from the employer’s assets. In the event of bankruptcy, federal law states that your employer’s creditors can’t make a claim on retirement plan funds.
So, all of your past contributions withheld from your paychecks that have been deposited in the trust belong to you and are protected by federal law. Since all employee contributions are immediately vested, you have a non-forfeitable rights over your funds in employer-sponsored qualified retirement plan account.
What 401(k) funds might be at risk?
There are four type of 401(k) contributions that you may a smaller chance of getting back, if at all.
1. Employer contributions with a vesting schedule
Unlike employee contributions, some employer contributions may be subject to a vesting schedule.
Cliff vesting: An employee doesn’t gain a full claim on these employer contributions until they complete a required number of years of service (commonly, 1 year). This vesting schedule is used to retain top talent. If your employer closes up shop before you’re fully vested on those funds, you may be out of luck.
Graded vesting: In this case, you gradually gain rights to employer contributions (e.g. 20% on first year and 20% each year thereafter). At the time that the company goes out of business, all employer contributions to which you’re fully vested you get to keep. The unvested portion may or may not get to you.
ERISA states that employees have a right to 100% benefits they have earned at the time of the plan termination, even those that you would have lost if you had left the employer. However, the reality is that companies can only vest employees on employer contributions to the extent that a plan is funded. Unlike most defined benefit plans, any defined contribution plan, such as a 401(k), isn’t insured by the Pension Benefit Guaranty Corporation (PBGC).
2. Matching or profit-sharing contributions
The U.S. Department of Labor allows employers to deposit matching or profit-sharing contributions to the trust account on a quarterly, semiannual, or annual basis. So, if you received news that you were going to receive a portion of last year’s profits just before you found out about the company shutting down, chances are that the money never made it to the trust account holding all protected funds. On top of that, these employer contributions may also be subject to a vesting schedule.
3. Employee contributions that happened right before company termination
Time is money. Even a couple of days can make a big difference in getting your 401(k) funds. Companies have up to 15 business days from the end of the month when an employee contribution took place to deposit the money in the trust account. Some companies may close their doors so fast that there may not be anybody there to process the transfer on time, leaving your very last employee contribution up in the air.
4. Company stock
If your company closes down and is now worthless, then so is your company stock. If the company is acquired by a third party, then you might be able to get back some cents on the dollar of your company stock. This is a good example of why it’s recommend that you don’t put all your retirement dollars in one basket.
What about unpaid 401(k) loans?
There are many reasons why it doesn’t make sense to take a loan from your 401(k). Here’s another one of them: If your company goes out of business, the outstanding balance on your 401(k) loan becomes due within 60 days of the day you were terminated. If you’re unable to come up with the payment by the deadline, the unpaid portion becomes taxable income, which will trigger the applicable income taxes. Those under age 59 1/2 will also have to pay a 10% early withdrawal penalty from the IRS. Certain states may charge additional income taxes and penalties. All of this would leave you with a large tax bill for that year’s tax return.
Whatever portion you don’t pay back you will not be able to roll over (more on that in just a bit) to a new employer-sponsored retirement plan.
What are my options with my 401(k) after the company goes out of business?
Once you know the exact total of your fully vested 401(k) funds, then you may have up to five options.
Option 1: Leave your money in the old 401(k)
Usually, having multiple 401(k) accounts floating around is not recommended. However, there are some scenarios in which it would make sense, especially given a company termination scenario.
The first case: In the event that your 401(k) continues to exist and you’re at least 55 years old by the the date of company termination, then keeping the funds in the old 401(k) may make sense because distributions would be exempt from the 10% early withdrawal penalty. If you lack an emergency fund or don’t know how long it will take you to find new employment, this tactic may help you to have a buffer against emergency expenses.
The second case: Your plan may have a particular feature that is very attractive to the plan holder. For example, my previous workplace 401(k) plan offers me access to Berkshire Hathaway shares at zero cost. I can acquire fractions of a share, which isn’t necessarily possible with other plans or individual investment accounts. For a list of common features of a great 401(k) that you may want to hold on to, here’s some recommended reading: What’s the Best 401(k) Plan?: Features You Should Be Looking For From Your Provider
Depending on the nature of the close out, the 401(k) plan of your prior employer may be merged with that of another company or acquired by a third party. In that case, you may have the option to leave your fund as is.
If you decide to do this, then make sure to report that you choose to stay in the new plan. Fail to indicate your instructions and your new plan administrator may decide to forcefully transfer you to an IRA of his choosing. And the new choice may not be the best match for your financial needs! Even worse, the investment return on those forced-transfer IRAs ranges from 0.01% to 2.05%, according to a 2014 report from the U.S. Government Accountability Office (GAO).
Option 2: Roll over to a new employer-sponsored 401(k)
If you’re able to find a new job offering an employer-sponsored 401(k) or other qualified retirement plan accepting rollovers within 60 days, complete a direct rollover of eligible funds into the new plan. A direct rollover is one way to keep deferring income taxes until retirement age.
Make sure to keep documentation of the entire process and a copy of IRS Form 1099-R as proof that you didn’t withdraw your funds and rolled them over instead.
For more details refer to How to Roll Over Your 401(k).
Option 3: Roll over to a traditional IRA or Roth IRA
If you’re unsure about whether you’ll be able to secure a new job that will offer a retirement plan within 60 days, then completing a direct rollover into a traditional IRA is your best bet. One of the advantages of a traditional IRA is that many financial institutions, including banks and credit unions, offer these type of retirement accounts so you’ll have many options to choose from. Another advantage is that unlike some 401(k) plans, all IRA plans accept rollovers from 401(k)s.
In the event that you think that your job hunt will take several months or decide to take this time as an opportunity to do something else (travel, go back to school, etc.), consider converting your 401(k) funds into a Roth IRA. Here’s why. Imagine that you only worked four months out of the year and you were fortunate enough to have an emergency fund to cover you for the rest of the year. Assuming that you only do some small part-time work during this time, this will be one year in which you will have very small income to report. This could be a great opportunity to take advantage of a lower tax bracket and convert pre-tax contributions into after-tax contributions at a lower cost.
For more details on this option, review Should I Roll Over My 401(k) Into an IRA?
Option 4: Do an indirect rollover
With an account balance under $1,000, your employer can opt to cash out your 401(k) without your input and mail you a check, withholding the mandatory 20%. In this scenario, keep the check and complete a rollover into a new employer-sponsored 401(k) or an IRA within 60 days.
To complete an indirect rollover, you’ll have to come up with the withheld 20% out of your own pocket. However, you’ll be able to recuperate that 20% in your next year’s tax return.
A combination approach: Roll over most of funds and take a small cashout
When it rains, it pours. If you receive a double whammy from another unfortunate event, such as family emergency or large medical bill around the same time your company closes up shop, then you would be happy to find out that you can mix and match between your options. For example, you could do a direct rollover of 80% of your 401(k) funds and cash out the remaining 20%.
Keep in mind that your plan administrator will likely withhold the mandatory 20% from your cashout, so you won’t see the full amount. Still, it may provide you some much needed peace of mind being able to cover some or all of those unexpected expenses during a difficult time. While your distribution will be subject to applicable income taxes, you could avoid the 10% early distribution penalty if your old 401(k) plan provided hardship distributions. The rules for hardship distributions vary per plan and plan administrators aren’t required to offer hardship distributions at all. Make sure to check with your plan administrator for more details.
The bottom line
The end of your previous company doesn’t mean the end of your nest egg. Most of your contributions are protected by federal law and you’ll have chances to rolling over those monies to a new retirement account. Make sure to evaluate all of your options and understand the rollover process to prevent triggering taxes and potential penalties. While this may be a difficult time, keep the majority of your funds in a retirement plan. Your future self will thank you that you did. We wish you the best of luck with everything!
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Article By
Damian DavilaDamian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.
