As you may know, one of the primary advantages offered by employer-sponsored plans, such as 401ks, is the employer match. This is money your employer puts into an account for the sake of building a retirement fund. However, if you’ve ever logged into your employer plan’s online 401k account, you may have noticed that you have two balances: a “vested” balance and an “unvested” balance.
But what’s the difference?
Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.
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Before we cover what vesting is, let’s cover how your employer calculates their contributions into your account. When your employer deposits money, they base the amount off of your own contributions and a formula that was established when the plan was drafted.
For instance, let’s say your plan offers a match of 100% of the first 3% of your salary you defer. After that, your employer will match 50% of the next 2% of your salary. If you defer 3% of your salary into the plan, your employer will match that contribution dollar for dollar. After 3%, your employer will match $0.50 on the dollar until you defer 5% of your salary in total. In simpler terms, your employer will match 100% of the first 4% of your salary that you defer.
The dollars that your employer contributes on your behalf can greatly assist in building a solid base of principal in your retirement account. That principal, coupled with compounding interest and tax-deferred growth, can really snowball with time. This is especially true if you know how to leverage your accounts properly. Understanding vesting in your 401k (or any other retirement plan) is an essential part of this process.
This article will explain vesting in detail, along with some important considerations to keep in mind as you continue to build your retirement assets.
Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. This article is not meant to be interpreted as investment advice. Always consider your personal situation – and the help of a licensed financial professional – when making any investment decisions.
What Is Vesting?
Vesting refers to the dollars that are “yours” outright in your employer’s retirement account, such as a 401k. In other words, this is the money that you could walk away with if you separated from employment.
It’s important to note that the money that you contribute to an employer’s plan is ALWAYS fully and immediately vested to you. Your employer can never take claim over those assets because they were yours to begin with.
Vesting ONLY applies to funds that your employer contributes to your account, including: employer match, profit sharing, etc.
Participants in a Safe Harbor 401k usually do not have to worry about vesting. This is because employer contributions are always immediately vested due to IRS guidelines.
However, if your plan is not a Safe Harbor 401k, you need to be aware of how vesting works. Perhaps more importantly, you need to know how it applies in your specific case.
What Goes Into Vesting?
When it comes to vesting, there are two important variables that you should understand. The first is the length of service requirements; the second is your plan’s vesting schedule.
We will cover these topics separately.
Length of Service
If your employer’s contributions to your 401k or other retirement plans fall subject to vesting, that means you have to satisfy a minimum amount of time in service with the employer. After this time, you’ll be able to claim the funds that your employer contributed for you. Companies set up plans this way in order to incentivize employees to stay with an employer longer.
Length of service is usually measured in years. If you have questions about how your employer measures length of service, check with your HR department or Plan Administrator.
Vesting schedule refers to the amount of years you must have in service to be vested in your employer’s contributions. Each plan is different in how it sets up this schedule.
Generally, there are two types of vesting schedules that you should be aware of:
- Graded Vesting, and
- Cliff Vesting
What is Graded Vesting?
Graded vesting schedules usually stretch out over a period of 5 to 6 years. 6 years is typically the maximum amount of years that a graded vesting schedule can extend. The employee must first satisfy a minimum amount of time in service (usually a year). Then, they will start being vested in a percentage of their employer’s contributions.
A typical graded vesting schedule looks as follows:
You meet the minimum service requirement, which grants you 20% vesting in your employer’s contributions. Then, on each anniversary of your initial service date, you vest another 20%. This continues until you finally reach 100% vested status.
This example makes it clear how the graded vesting schedule provides employees with incentive to stay with the company longer.
What is Cliff Vesting?
Cliff vesting is not stretched out the same way. If your plan is subject to cliff vesting, you must be an employee for a minimum amount of time before owning any portion of the employer’s contribution.
The good news is that you own the entire amount that the employer contributed as soon as you meet the requirements. Typically, the maximum cliff vesting schedule for a defined contribution plan, like a 401k, is 3 years.
In other words, if you are with the employer for 3 years, you are fully vested in their contributions versus having to stay employed for 5-6 years as with graded vesting.
The maximum years of service requirement for cliff vesting in defined benefit plans (like pensions) is typically 5 years.
The trade-off with cliff vesting is that you do not have a right to claim the employer contributions until you meet the cliff vesting length of service requirement. Cliff vesting takes longer for you vest fully, but you start vesting after satisfying the initial service period.
If you are currently weighing out job offers, you may want to inquire on the vesting schedule type for each employer’s plan, as that may be material in your decision.
What Happens If I Separate From Service?
If you separate from service and have “unvested” dollars in your employer’s retirement account, your employer has the right to rescind the money, or take it back in other words. The official term for this is a “forfeiture,” because you are forfeiting the right to take claim of the money that was contributed on your behalf.
Employers use forfeitures for several things, such as helping employees with plan costs, providing active employees with contributions, etc.
A common misconception about vesting is that it is reliant on the amount of time that the account has been open. As discussed earlier, that is not the case. Vesting is strictly tied to length of service, regardless of how long the account is open.
If you join an employer that offers a retirement plan, you can process a rollover of your vested plan balance to the new plan. You can also roll the vested dollars into an IRA if you prefer to not have the assets associated with an employer’s plan.
In either case, when you separate, you can walk away with what has vested to you. The rest goes back to the employer.
If you feel like you are entitled to dollars that have not vested to you, the best place to go would be your Human Resources department. They are in constant contact with your Plan Administrator. They can walk you through your official length of service on file and help you dispute any claims that you may have.
Should I Stay Until I’m Fully Vested?
This is a common question employees ask once they learn that they are subject to a vesting schedule of any kind. (Other contributions that follow a vesting schedule include equity awards like Restricted Stock Units (RSUs) or Non-Qualified Stock Options (NQSOs)).
As with anything related to your financial picture, it depends. There will always be opportunity costs in life that you have to measure.
If you are happy with your employment, and see yourself continuing to have a future with the firm, it’s probably an easy decision to stay. However, if the work environment is toxic, or you’ve received an opportunity elsewhere that is too good to turn down, you may want to give the decision some careful consideration.
However, if you are just a few months away from fully vesting in the plan balance, you may want to think about that before jumping ship. Weigh out the pros and cons of leaving versus staying. If one option has clear benefits above the other, that may take precedence.
A Final Word on Vesting in Retirement Accounts
A major part of navigating your financial picture is understanding the terms of your employer-sponsored benefits. Vesting in your 401k or other plans is usually an area that individual investors tend to overlook.
Knowing your vesting schedule can help you from a career planning and financial planning perspective.
If you have questions related to your employer’s matching provisions, contact your HR or Plan Administrator. Typically, all of this information is available on the Summary Plan Description (SPD). This is a document that highlights the benefits of your plan.
And, as always, take the steps that make the most sense for your financial future.
Have questions about vesting? Let us know!