Your employer might make generous contributions to your retirement plan or another benefit plan. But the money and any other benefits aren’t truly yours until you’ve complied with the plan’s vesting schedule, which dictates when you’ll get full ownership of those contributions.
What Is Vesting?
“Vesting” refers to your portion of ownership in money or other assets that have been contributed by an employer to your retirement, stock-option, or another benefit plan. Examples of assets subject to vesting include employer-matching contributions or a share of the company’s profits that amounts to a certain percentage of the employee’s salary.
If you are 100% vested in a plan, the full balance of the plan account belongs to you, which means that your employer can’t take the assets away from you for any reason. In contrast, if you only partially vested or have no vesting in the plan, you may have to forfeit some or all of the assets when the account balance is paid out—for example, if you leave your job or do not work for more than 500 hours per year for five years.1
Until you are fully vested, your account balance is misleading; even though you may see money in your account, you may still have to forfeit that money (or another benefit) in the future.
Basics of a Vesting Schedule
To encourage employee loyalty, employers frequently make contributions to your retirement or stock-option account subject to a vesting plan. This incentive program set up by a company determines when you’ll be fully “vested” in, or acquire full ownership of, employer contributions to the plan.
Through a vesting schedule, employers dangle their contributions in front of you like a carrot. The more years you work for the firm, the more of the contributions you get to keep. If you leave before you are fully vested under the plan, some or all of the funds return to the company.
Vesting doesn’t apply to any money you contribute yourself (it’s your money, and you get to keep it even if you leave the company). Whenever you make a contribution to your retirement plan at work, you are 100% vested in your own contributions. Vesting schedules apply only to funds that employers contribute on your behalf.
An employee’s own contributions to a plan are always considered to be fully vested, or owned, by the employee. In addition, vesting only applies to qualified defined-benefit plans, including 401(k) and profit-sharing plans. Other retirement plans, including SEP plans and SIMPLE IRAs, require contributions to be 100% vested.1
Vesting Schedules for Retirement Accounts
There are three basic types of vesting plans through which employees can acquire full ownership of employer contributions to a retirement or other benefit plan account.
Immediate schedules grant full ownership from the contribution date. Just as the name implies, employees with this type of vesting schedule are 100% vested in, and have full ownership of, their employer’s contribution as soon as it lands in their accounts.
Graded schedules increase vesting over time. This vesting plan gives employees gradually increasing ownership of employer contributions as their length of service increases, eventually resulting in 100% ownership. If an employee leaves before that period is up, she gets to keep only the percentage of the employer’s matching contributions in which she is vested. Federal law sets a six-year maximum on graded vesting schedules in retirement plans.
Cliff schedules confer benefits on an all-or-nothing basis. This vesting schedule transfers 100% ownership to the employee in one big chunk after a specific period of service (for example, one year). But until completing that service period, employees have no ownership in employer contributions and will forfeit them all if they leave before that period expires. When they reach the fully vested date, they will own all the employer contributions. Federal law requires that cliff vesting schedules in qualified retirement plans, such as a 401(k) or a 403(b) plans, not exceed three years.12
Vesting Schedules for Stock Options
Under a stock-option plan, an employer can provide employees with stock options, which give them the right to buy company stock at a set price regardless of the stock’s current market value. The expectation is that the stock’s market price will rise above the set price before the option is used, giving the employee a chance to make a profit.
Stock-option plans generally come in graded or cliff vesting schedules. In a cliff plan, the employee gets access to all of the stock options on the same date. In a graded plan, employees are allowed to exercise only a portion of their options at a time.
If employees, for example, are granted options on 100 shares with a five-year cliff vesting schedule, they must work for the company for five more years before they can exercise any of the options to buy shares. In a five-year graded schedule, they might be able to buy 20 shares per year until they reach 100 shares in the fifth year.
Because most stock options are not part of an employee’s retirement plan, their vesting schedules are not limited by the same federal rules that govern matching contributions.
Example Benefits Under Different Vesting Schedules
Before taking a new job and leaving your company, it’s important to calculate what, if any, portion of employer contributions you would get to keep under your firm’s vesting plan. These scenarios can serve as a reference when making employment decisions.
Tom’s employer provides a dollar-for-dollar annual matching contribution of up to 5% percent of his salary of $50,000 to his 401(k) account. To take advantage of the match, he contributes the full 5% during his tenure at the company. He leaves the company after two years with a $10,000 account balance ($5,000 in employee contributions and $5,000 in employer contributions).
Under an immediate vesting schedule, Tom would fully own any money given to him by his employer from the date of contribution. He would get to keep the full $5,000 in employer contributions (along with the money he contributed). This means he would not be any worse off by leaving the company now versus later.
Let’s say that Tom’s 401(k) plan vests on a five-year graded schedule that grants 20% ownership after the first year and then 20% more each year until he gains full ownership (100%) after five years. After two years, Tom would be 40% vested. He would keep only $2,000 of the $5,000 matching contribution (0.4 multiplied by $5,000) and forfeit the other $3,000. It may still make sense for Tom to leave the company now, as he would have to stay another three years to become fully vested.
Under a three-year cliff vesting schedule, Tom would have no ownership of employer contributions to the plan after two years. He would have to forfeit the full $5,000 given to him during his tenure. Tom may want to stay at the company for one more year if keeping that $5,000 is important to him.
Final Thoughts on Vesting
Understanding what vesting is and the details of the vesting schedule at your company can help you plan for your financial future and reduce or eliminate the possibility of forfeiting any employer contributions when you leave the firm. While you shouldn’t make employment decisions on the sole basis of a company’s vesting schedule, calculating your benefits under different vesting plans can help you properly time your departure to fully claim money and other assets that your employer may give you.
If you’re not sure about your vesting schedule, contact your human resources department or check your benefits manual to learn more about any vesting plans that your retirement or other benefit accounts may impose.