401(k) Fears, Timing a Roth Conversion, More

QUESTION: What happens if the company that services my 401(k) goes bankrupt? Is there any risk to my funds?

—Neil Rosenberg, Valley Forge, Pa.

ANSWER: The money invested in your 401(k) is largely protected on a few different fronts. Broadly speaking, 401(k)s are overseen by the Employee Retirement Income Security Act (ERISA), which requires that the money be held in a trust separate from your employer’s business assets and is not accessible to creditors should your employer go bankrupt. Your employer must also assign a fiduciary to oversee the management of the 401(k) plan. Should the plan not be run properly—if, say, contributions aren’t deposited in a timely manner—that fiduciary can be liable and plan participants must be compensated, says Rick Meigs, president of 401khelpcenter.com, an independent research firm. 

Then there’s the manager of those investments, often a broker or the brokerage arm of a mutual fund firm. Should the management company fail, other consumer protections kick in. During any type of failure, “the assets themselves are not at risk,” says Bradford Campbell, of the Employee Benefits Security Administration, the government branch that oversees ERISA. Even so, check your statements regularly to prevent any nasty surprises.

QUESTION: With the stock market tanking, would it be a good time to roll over my traditional IRA to a Roth?

—Pat Mix, Hilton Head, S.C.

ANSWER: Way to find that silver lining! Yes, converting to a Roth when your account balance is down spells a smaller tax bill. That’s because each dollar you convert (assuming your IRA doesn’t hold nondeductible contributions) is taxed as ordinary income, so fewer dollars means less tax. To qualify for a conversion, you must have adjusted gross income of $100,000 or less, although in 2010 this restriction will be removed. Also, if you make the conversion only to find that your account balance dips even further, you can redo it by converting the account back to a traditional IRA and then back again to a Roth, so you aren’t paying taxes on gains that are long gone.

QUESTION: My wife and I get a significant part of our income from two bond funds. One just saw its Morningstar rating drop from four stars to three stars. Do we stay put or change?

—Julian Schrock, Stowe, Vt.

ANSWER: Morningstar’s ratings (which run from one to five stars) wield a remarkable amount of power. A move from four stars to five results in cash intakes 25 percent above the norm in the first six months, according to a recent study by researchers from the Federal Reserve Bank of Atlanta and the University of Oregon.

But “you have to take the rating with a grain of salt,” says New York City–based financial adviser Gary Schatsky. “It’s the first step.” So before you give in to a knee-jerk reaction to sell, investigate what’s going on. Morningstar’s ratings are evaluations of historical performance. The calculations are based on risk- and cost-adjusted returns using a minimum of rolling three-year data (longer periods are incorporated for older funds) for specific types of funds. Increased volatility, sluggish returns or the falling off of good returns several years earlier could cause a drop in a fund’s rating—although, generally, a drop from four stars to three shouldn’t cause much alarm, says John Rekenthaler, Morningstar’s vice president of research. Review the most recent statements and see what has been written about the fund recently.

Bottom line: If you don’t see anything worrisome, you probably don’t need to sell.