- Vesting refers to an employee's ownership of their retirement plan or stock options.
- Employers typically set vesting schedules that grant ownership incrementally over a fixed period of time.
- For newer companies, longer stock-option vesting periods can be useful for retaining employees.
The concept of 401(k) vesting is a cornerstone of retirement planning. While you always own your own contributions to a retirement plan, the definition of being vested in retirement refers to your ownership of employer contributions.
Understanding what vesting means for stock options can also be key to your financial future. Fortunately, vesting is a fairly straightforward concept that basically just means it could take time to fully own your employer's matching contributions or stock option grants.
Knowing what it takes to be fully vested and maximizing your 401(k) contributions can help you get the most out of the best retirement plans.
Here, we'll take a closer look at what vesting involves, particularly for retirement plans.
What does it mean to be vested?
A simple vested meaning is ownership. In terms of what vested means in employer-sponsored retirement plans like a 401(k), this refers to the ownership of the assets in their account, because not all retirement contributions from an employer are owned by the employee right away.
This particularly shows up when employers contribute a matching amount to an employee's yearly retirement savings, up to a predetermined limit, such as matching the first 3% of your salary.
So, if you earn $50,000 a year, your company might match up $1,500 (3%) in retirement contributions. However, this money isn't always yours to keep right away. Vesting refers to the ownership level here, which can vary by company and situation. For example, the matching contributions might vest over five years, where after your first year, you might be 20% vested, meaning you only own 20% of that $1,5000 match.
Once employees reach a 100% vested status in their retirement account, they receive complete ownership of the accumulated funds. This ensures that the employer has no right to reclaim any portion.
Vesting can also apply to other areas, such as ownership of company stock. An employer might contribute a retirement match in terms of shares of company stock, or a company might grant stock options as part of normal compensation. However, these too might vest over time, rather than being fully owned right away.
However, contributions from your own paycheck into your retirement plan are legally owned by you in full, regardless of your vesting status. Only contributions from your employer are in danger of being reclaimed if you leave before you've become vested.
How retirement vesting works
Retirement vesting follows a pre-determined timeline called a vesting schedule, wIf an employer does not make matching contributions 100% vested right away, then they use a timeline called a vesting schedule, which must comply with Internal Revenue Code (IRC) rules. These rules include minimum vesting schedules, such as how 401(k) plans can either involve no vesting until an employee works at the company for three years and then becomes 100% vested, or the employer could have a six-year gradual vesting schedule, increasing vesting by 20% a year.
However, an employer could set their own schedule that exceeds these baseline requirements, such as vesting gradually over five years instead of six.
"The main reason employers set up vesting schedules is for employee retention," says Henry Hoang, CFP and founder at Bright Wealth Advisors. "Hiring and training new employees is very expensive for businesses, so a vesting schedule allows a business to reward employees for their loyalty while minimizing financial risk should employees decide to quit before their benefits are fully vested."
With a fully vested employee, the employer's contributions to the employee's retirement accounts become nonforfeitable, and the company can't take them back for any reason.
But if you leave the company before becoming fully vested, you would forfeit whatever percentage of employer contributions you hadn't yet been awarded under the vesting schedule. In some cases, that means all of the employer contributions made to that account.
Pension plans can also have a vesting component. While pension plans are less common today, they promise a specified monthly benefit. Moreover, vesting for pension plans determines your eligibility to receive this benefit.
Employees must be 100% vested by reaching full retirement age, regardless of the contracted vesting schedule. Employees may also become completely vested if the company's retirement plan is terminated or they qualify for the business's early retirement provisions. Death or disability can also trigger immediate vesting depending on what a plan chooses.
Types of vesting schedules
Vesting schedules are written into the policy of your employer-sponsored retirement plan and can vary from business to business. They typically fall into two main categories: immediate or gradual. Cliff vesting and graded vesting are types of gradual vesting schedules.
Under IRC regulations, vesting can take no longer than six years under a graded schedule or three years if following a cliff schedule. You can access your 401(k) vesting schedule in your retirement plan's policy.
Here are three types of vesting schedules.
Graded vesting
Many 401(k)s or other employer-sponsored retirement plans use a graded vesting schedule. This means vesting occurs incrementally according to a predetermined timeline. During the first year of employment, it's possible that an employee may not become vested at all. For each additional year of working at that company, employees become increasingly vested.
Here's an example of a six-year graded vesting schedule:
| Years of employment | Vesting percentage |
| 1 | 0% |
| 2 | 20% |
| 3 | 40% |
| 4 | 60% |
| 5 | 80% |
| 6 | 100% |
Cliff vesting
With cliff vesting, the employer match becomes vested all at once on a set date. For example, if an employer chooses a two-year cliff vesting schedule, the employer's contributions will become 100% vested on the employee's two-year work anniversary.
Cliff vesting schedules are required to offer full vesting status in no more than three years, according to the Pension Protection Act of 2006.
Here's an example of a three-year cliff vesting schedule:
| Years of employment | Vesting percentage |
| 1 | 0% |
| 2 | 0% |
| 3 | 100% |
Immediate vesting
Although less common, immediate vesting is also an option employers can select. With an immediate vesting schedule, employees gain access to an employer's contributions from the start.
Some retirement plans such as SIMPLE 401(k)s, SEP IRAs, and safe harbor 401(k)s offer immediate vesting.
An example of vesting
It's typical to see an employer match 3% to 6% of an employee's salary. Here's an example of a four-year vesting schedule when 25% becomes vested each year. This example is what it looks like for the employee with a $50,000 salary and a 3% employer-contributed benefit. The 3% match would be $1,500 a year or $125 a month.
This is for illustrative purposes for employer contributions and doesn't take into account salary increases, market appreciation, or employee contributions.
| Year | Percent vested | Employer contributions - 3% of a $50,000 salary | Amount an employee is eligible to keep based on a vesting schedule | Total of employer contributions vested in the employee |
| >1 | 0% | $125/month | 0 | 0 |
| 1 | 25% | $1,500 | $375 ($1,500 x 25%) | $375 (25% vesting of year 1.) |
| 2 | 50% | $1,500 | $750 ($1,500 x 50%) | $1,500 ($750 from 50% vesting of year 1 + $750 from 50% vesting of year 2.) |
| 3 | 75% | $1,500 | $1,125 ($1,500 x 75%) | $3,375 ($1,125 at 75% vesting of years 1 - 3) |
| 4 | 100% | $1,500 | $1,500 ($1,500 x 100%) | $6,000 ($1,500 at 100% vesting on years 1 - 4) |
After the four-year mark, when this employee is fully vested, 100% of the employer contributions now belong to the employee.
Why do employers require vesting periods?
It's common to see employers using a vesting schedule to give workers an incentive to stay. Relatedly, companies seeking investment, such as from venture capital firms, might have an easier time raising money if they vest, especially for compensation like stock options.
Companies looking to attract top talent can vary when it comes to vesting periods. Be sure to ask what an employer's vesting schedule is, the match percentage, and if it's negotiable.
To encourage employees to stay
With graded vesting periods, employees will own a greater percentage of the employer contributions in each successive year the company retains them. The longer they stay with the company, the greater the percentage of vested employer contributions they will have. Cliff vesting schedules also encourage employees to stay, but perhaps not as long as some graded schedules.
To seek venture capital
A vesting schedule is also essential for businesses seeking venture capital.
Michele Schueli, managing partner and venture capitalist (VC) at ARMYN Capital, says early-stage financial backers of companies often encourage the use of vesting schedules for stock options, usually four years with a one-year cliff for employees or longer for company founders.
"Disregarding vesting is a problem for investors as it leads to a capitalization table filled with 'dead equity,' which is equity owned by founders/employees who left the company and are not adding any value," Schueli says. "Ultimately, 'dead equity' blocks result in a chaotic capitalization table, which makes it difficult for investors to fund the company, even if all other boxes have been ticked."
The significance of vesting
Understanding the role of vesting in your retirement plan is essential for several reasons, such as:
- Retirement planning: Knowing when and how your account is vested can significantly impact your retirement savings and financial planning. If you're not fully vested, part of your 401(k) balance is not legally yours yet. Understanding your vesting schedule can help you gauge how much you need to save for retirement.
- Job mobility: Awareness of your vesting status is vital when considering a job change, as it affects the portion of your retirement savings you can retain.
- Maximizing compensation: By staying with an employer until you're fully vested, you ensure you don't leave any money on the table. But if you are going to change jobs before fully vesting, that might factor into the salary or benefits you negotiate at your next job, especially if you're getting recruited to leave your current employer.
Understanding vesting in retirement plans
When it comes to vesting, timing is critical for employees. If an employee knows that staying another two months means they gain access to thousands more in their retirement account, they can plan their tenure at the company accordingly.
Businesses have different ways of vesting their employees, and it's an often overlooked aspect of an applicant's job search. Understanding vesting and what a potential employer is really offering in terms of compensation for the job, both now and for your future, can make a big difference in your long-term investing returns.
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FAQs about vesting
What does it mean when the money in your 401(k) is vested?
Being fully vested in your 401(k) means you own all the money in the account, including employer contributions. If you're only partially vested, you can't actually take the full amount with you if you change jobs before fully vesting.
What does fully vested mean?
Being fully vested means you have full ownership of the assets in question, such as employer contributions to your retirement account or stock options. If you're not fully vested, you might get these contributions or grants but not actually own those assets completely.
Is vesting a good thing?
Vesting is considered a good thing from an employer's perspective, as it encourages long-term employment while providing future financial security. Employees likely wish to fully vest sooner than later so that they own those assets. Understanding vesting as it relates to your specific employer is crucial to maximize financial benefits and align them with your career and retirement plan.
What are the three types of vesting?
The three primary types of vesting in retirement plans include immediate vesting, cliff vesting, and graded vesting. Immediate vesting is where employees gain instant ownership of employer contributions. Cliff vesting is when employees are required to fulfill a specific tenure before earning full ownership all at once. Graded vesting is where employers grant ownership incrementally until reaching 100% vesting after several years. Each vesting type aims to align employee retention goals with secure retirement benefits.
Why is it important to be vested?
It's important to be vested to have full ownership of assets such as employer matches in your 401(k). For example, if your employer matches $1,000 per year in your retirement account but you're not vested, you're forfeiting that money if you leave that employer. If you wait until you're vested after, say, three years, that means that $3,000 in matches over three years are now yours.
