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Vesting is an important concept in the world of employer retirement plans. For most people, they’ll encounter the term vesting when they’re dealing with their employer-sponsored retirement plans such as a 401(k) or 403(b) plan. In this context, vesting refers to how much of your employer match is actually owned by you. Here’s how it all works.
What vesting means
Many employer-sponsored retirement plans offer an employer match on any contributions made by the employee. For example, an employer might match 50 percent of the first 6 percent of an employee’s salary deposited into the account. In this case, the employee contributes 6 percent and receives an additional 3 percent from the employer, resulting in a total of 9 percent. That’s free money, and it’s one reason that experts recommend employees take maximum advantage.
But here’s the catch: That match is not all yours from day one. Yes, your contributions always belong to you, but the money from your employer may be required to vest — potentially for years — before it becomes entirely yours. For the money to vest, you’ll need to remain an employee of the company until you’ve completed the required vesting period.
If you don’t meet the vesting requirement, you’ll forfeit any matching funds that are unvested.
Other benefits such as stock or option plans for employees may also have a vesting period.
What happens when you’re fully vested?
Once you’re fully vested, the full value of your employer’s contributions are yours and typically all future employer matches vest immediately. These will continue to be invested according to your plan and will be available to you in the event you leave the company. At that time, you’ll have the option of rolling over the account into the plan offered by your new employer, or into an IRA, which gives you greater investment options.
Here are some additional details about vesting that are useful to know:
- Vesting often takes place over a few years, typically three or four years, though some employers have immediate vesting.
- An employer match often vests proportionally each year, and this process is called graded vesting. For example, if your match vests over four years, one-fourth of the total matching amount will vest each year.
- Another type of vesting – cliff vesting – takes place all at once. Once you surpass the vesting period, 100 percent of your match belongs to you.
Why would a company require a vesting period? A vesting period may reduce employee turnover and keep employees on the job longer, helping reduce the employer’s costs.
However, many companies won’t require a vesting period, and in these cases, your match becomes all yours as soon as it’s deposited into your account. That doesn’t mean you can withdraw your retirement plan money without penalty, but you’ll be able to take the full amount – your contributions plus the employer match – with you no matter when you leave your job.
What happens if you leave a job before you’re fully vested?
If you’re not fully vested in your company’s plan when you leave, then you’ll lose any unvested funds. To be clear, any money that you contribute to a retirement plan will always be yours to keep. Only the unvested money contributed by the company will be forfeited if you leave.
In addition, once you reach the vesting threshold, any subsequent matching funds from your employer vest immediately. So if you have a three-year vesting period, for example, any matching funds from that time on (say, in years four or five) will immediately become yours.
An example of vesting
Graded vesting is among the most typical forms of vesting, and it offers employees a percentage of their match each year until the employee owns the whole match and any future matches. Let’s run through an example so you can see how it works in practice.
Imagine you contribute 4 percent of your salary and receive a 100 percent match on those funds. The match vests over a four-year period. For the simplicity of running the numbers, assume that you’re contributing $4,000 annually, so you receive $4,000 in matching funds.
Here’s how much of the annual $4,000 matching contribution would be vested over the first five years:
|Year / Percent vested||Year 1||Year 2||Year 3||Year 4||Year 5||Cumulative amount vested|
|1 / 25 percent||$1,000||–||–||–||–||$1,000|
|2 / 50 percent||$2,000||$2,000||–||–||–||$4,000|
|3 / 75 percent||$3,000||$3,000||$3,000||–||–||$9,000|
|4 / 100 percent||$4,000||$4,000||$4,000||$4,000||–||$16,000|
|5 / 100 percent||$4,000||$4,000||$4,000||$4,000||$4,000||$20,000|
After Year 1, you own just 25 percent of your match, or $1,000 of the $4,000 you’ve been given. At the end of Year 2, however, this vesting schedule means you own 50 percent of what you contributed in Year 1 – $2,000 – plus 50 percent of what you contributed in Year 2 – $2,000. So cumulatively you own a total of $4,000 in employer matching funds that have vested.
By the end of Year 4, all the money that has been matched becomes yours alone. And in subsequent years, any matched funds immediately vest, so you have full ownership of them.
If you have your 401(k) funds invested in stocks and bonds, then the actual amount of the money in the account can be substantially higher (or lower) than what was matched originally.
Despite the annoyance of a vesting schedule, it’s important to take advantage of matching funds from your employer. And you do need to understand any economic consequences of deciding to leave your employer before your matching funds have vested completely. If the numbers work for you, it could make a lot of sense to wait a bit of extra time to secure a greater vested match.