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How Vesting Works and Why It's Important

| January 03, 2018
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Vesting is the process through which an employee accumulates non-forfeitable rights over his or her employer contributions or employer-provided stock incentives deposited into the employee’s qualified retirement or pension plan. The fundamental purpose of vesting is to exchange employer-provided assets for the employee’s loyalty, longevity and continued high performance.

Any employee who participates in a defined-contribution retirement plan such as a 401(k), 403(b), or 457(b) owns all the money he or she contributed directly into said account, regardless of the length of time on the job. Granted, each retirement plan is subject to its own rules and regulations regarding when money can be withdrawn, fee schedules and penalty assessments, but if these funds are rolled over into another tax-deferred retirement plan or rollover IRA, the entire amount of the account can be transferred.

Some Employers Use Vesting Schedules

However, when an employer matches an employee’s contributions into a retirement plan, vesting concerns arise. While the employer may regularly match all employee contributions, the employer may also draw out ownership over a specific period of time through what is known as a vesting schedule. Thus, when the employee reaches 100% ownership of employer-matched funds, he or she is considered to be fully vested.

Each employer’s vesting schedule is unique to that particular company and spells out how and when the employee acquires full ownership of the asset in question. In most cases, vesting rights accrue based on the employee’s length of time on the job. 

Types of Vesting Schedules

There are three basic types of vesting schedules: immediate, cliff, and graded.

Immediate vesting: For some benefits—such as salary-deferred retirement plan contributions including Simplified Employee Pension (SEP) and SIMPLE IRA employer contributions—vesting is immediate. Other benefits—such as employer contributions to an employee’s 401(k) plan—may vest immediately or after a specific period of time via a cliff or graded vesting schedule.

Cliff vesting: Cliff vesting enables an employee to achieve 100% ownership of employer contributions after a set number of years. In most cases, this period of time cannot exceed three years.

Graded vesting: Graded vesting provides the employee ownership of a specific percentage of his or her employer’s contribution each year. This type of vesting occurs incrementally over time. The most common graded—or graduated—schedule typically fully vests after five years, and, by law, this period cannot exceed six years.

It is the employer’s prerogative as to which type of vesting schedule to employ. Here are three examples: a simple cliff vesting schedule, a five-year graded vesting schedule, and a six-year graded vesting schedule.

 

Years of service

Cliff

5-year Graded

6-year Graded

1

0%

0%

0%

2

0%

25%

20%

3

100%

50%

40%

4

100%

75%

60%

5

100%

100%

80%

6

100%

100%

100%

 

Keep in mind, however, that even if an employee becomes fully vested, there are still rules and regulations regarding withdrawing funds such as waiting until retirement age before being able to make penalty-free withdrawals. Additionally, 100% vesting is typically only required by the time the employee reaches normal retirement age or when the plan is terminated. (For related reading, see: How Do You Calculate Penalties on a 401(k) Early Withdrawal?)

Stock Option Vesting

Not all employer contributions are cash. Some publicly-traded companies may offer employee stock options, which give the employee the right to purchase or exercise a certain number of company shares at a set price.

According to the National Center for Employee Ownership (NCEO), other types of stock options that have been gaining in popularity over the past few decades include restricted stock, phantom stock, and stock appreciation rights. Regardless of the type of stock options offered, most of these plans vest in largely the same way as matching contributions.

How Leaving a Job Affects Vesting

Before leaving one’s job, it is important to weigh the pros and cons of such an action on one’s vesting time. For example, if an employee is only a few months away from becoming fully vested, then he or she may wish to wait it out and become fully vested to take advantage of the associated privileges.

Todd Wilhoit contributes articles for Investopedia.com. See this one and more here.
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