What Is Vesting and How Does It Work in a Retirement Plan?
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Many companies offer an employer-sponsored retirement plan, such as a 401(k) or 403(b), and match a portion of their employees’ contributions. The company match is often referred to as free money, and it’s a great perk. But if you’re starting a new job, you’ll want to review the plan’s vesting schedule—the rate at which the company’s contributions become yours to keep.
Here’s everything you need to know about vesting in your 401(k) and other employer-sponsored retirement plans.
What Does Vesting Mean?
Vesting refers to the ownership of the money in your employee-sponsored retirement account. It can be helpful to think of the funds in your account as split into two buckets. One bucket gets filled by your contributions, and the other gets filled by your employer’s contributions.
The money you contribute is always 100% vested—it was yours before you contributed it and remains yours once it’s in the retirement account. However, it might take time for your employer contributions to vest, and you could lose all or part of that bucket if you leave before you’re fully vested.
For example, say you contribute $1,000 to your 401(k) plan, and your company matches that with a $1,000 contribution. Everything gets invested in the same fund, and after six months, your total account balance is now $2,500.
If you leave the company and are 0% vested, you can’t take any of the company contributions ($1,000) or the earnings from those contributions ($250) with you, although you’ll keep all the money you contributed and those earnings. If you’re 50% vested, you’d get to keep half the company contributions and earnings.
Companies can set up different vesting schedules, and they all serve as ways to encourage new employees to stay at the company for at least a few years.
The good thing is your vested percentage applies to all former and future contributions, along with the earnings from that money. In other words, you don’t need to wait for new employer-contributions to vest again. Once you’re 100% vested, all the money is yours.
The Three Vesting Schedules
Vesting schedules generally take one of three forms. The specifics can vary depending on your employer and arrangement, and there are federal laws that employers must follow when creating a vesting schedule.
If your plan offers immediate vesting, then your employer contributions are fully vested from day one. This may be the best arrangement for employees as you don’t need to worry about losing any portion of the employer match.
If your plan has graded vesting, part of your employer contributions will vest each year. For example, you might start with 0% vested, but then get 25% vested for each year of employment. Your vesting schedule could look like:
- Year 1: 0%
- Year 2: 25%
- Year 3: 50%
- Year 4: 75%
- Year 5: 100%
With this arrangement, you’ll need to work at least five years at the company if you want to take the entire employer-contribution bucket with you when you leave. At most, employers can use a six-year vesting schedule for graded vesting plans.
You quickly go from nothing to everything with cliff vesting, and your vesting schedule could look like:
- Year 1: 0%
- Year 2: 0%
- Year 3: 100%
Your cliff-vesting schedule could be shorter, perhaps you get 100% after your first full year. However, if a company uses a cliff vesting schedule, employees must be 100% vested after three years.
Vesting Schedules and Rules Can Vary
The rules and schedules can also depend on your employer and the type of retirement plan the organization offers. For example, government and church pension plans may have different vesting rules. Or, if you open an individual retirement account (including SEP and SIMPLE IRAs for self-employed people), then the contributions will always be 100% vested.
Some companies also offer their employees stock or equity options in addition or instead of a retirement plan. These options may have similar types of vesting schedules, meaning you might earn the ability to use your options and buy the company’s stock (often at a discounted price) over time.
Leaving a Job Before You’re Fully Vested
If you’re thinking of leaving your job, you may want to ask your human resources department about your retirement plan and what your vested balance would be at the time you plan to leave.
Making a move could still be a good idea, even if you’ll lose the unvested portion of your retirement account. However, you’ll want to consider how much you’re losing, how long you’d need to stay to become fully vested, and if leaving money on the table is ultimately worth it. You also might be able to use this as a negotiating chip—particularly if you’re being recruited—and ask your new employer to offset the money you lose with a sign-on bonus.
Whether or not you’re fully vested, you should have a plan for what to do with your 401(k) when leaving a job. Unless you’re at least 59 ½ years old, you could have to pay a 10% penalty to withdraw the money early. Leaving it be isn’t always an option, and even when it is, that might not be the best choice.
Two popular routes that allow you to avoid early withdrawal penalties are transferring the money to your new employer’s 401(k) plan or rolling over your 401(k) into an IRA. What’s best may depend on your new employer’s offering and how hands-on you want to be with managing your retirement savings.
How vesting fits into the big picture
Vesting is just one piece of your retirement puzzle. Learn more about retirement planning on our blog, and explore how Quicken can help you plan for retirement by tracking your retirement accounts all in one place.