If your employer stock is inside a Qualified Retirement Plan there should be no tax cost for diversifying. If your employer stock is held outside an employer plan, you may have to pay capital gains tax. But all experts agree that diversification takes precedence over taxes. If you are not maximizing contributions to QRP and IRAs, at a bare minimum you should sell enough employer stock each year to fund the legal limits for contributions to the world’s best tax shelters. Paying a lower capital gains rate (5-15%) in order to harvest a higher income tax savings (15%) is usually a sound wealth building strategy.
Securities law prevents a mutual fund from claiming to be diversified if it has more than 5% invested in any single security. Because it’s employer stock, the risk is doubled for you. You are exposed to the same double jeopardy suffered by employees of Enron, Worldcom, MCI, etc. during the hi-tech crash. When you own too much employer stock, you subject both your income and your investments to all the fortunes and risks of one company. You are unnecessarily betting your present and future on the success of one company. Because this risk can be diversified away, financial economists call it “uncompensated risk”. There is no extra return for taking this risk. It is not easy to rebuild 20-30 years of saving if you lose your job and a large portion of your portfolio at the same time. With the loss of your investments and your income, the future usually looks pretty bleak. The older you are, the harder it is to recover.
Most people just don’t seem to comprehend the risk they are taking. The average life expectancy of a company is 12.5 years. A full one-third of the companies listed in the 1970 Fortune 500 had vanished by 1983. The life expectancy of small companies is even shorter. Do you remember the media stories of employees of Enron, MCI, Worldcom and small hi-tech companies who were devastated by the tech crash of 2000 because they had everything in employer stock? Did the warning make a difference? Apparently not. The same thing happened in 2008. Employees of Lehman Brothers, Countrywide, AIG, etc lost both their jobs and retirement portfolios heavily invested in company stock. If you think it is foolish for others to invest so much of their portfolio in one stock shouldn’t you apply the same standard to yourself?
Everyone agrees with “Don’t put all your eggs in one basket”. Even more hazardous is to put both your present and future financial well-being into one egg.