Ask GFC 032: How Does 401(k) Vesting Work?

We talk a lot about retirement plans here on Good Financial Cents, but one part of the retirement subject we don’t discuss enough is 401(k) vesting.

Not all plans have it, but many do. And some have very generous employer matches, making the question of 401(k) vesting an important one.

An Ask GFC reader asked the following question:

“I am a 401(k) Plan participant which has a graded vesting schedule of 6 years. I have completed 4 years and am not working with the company since 2005. I am 55 years old. Am I 100% vested for employer’s contribution?”

I’m going to jump right to the answer to the reader’s question, and I’ll explain the details of that answer as we go along.

Since the reader was in a plan that had a graded vesting schedule of six years, and he only completed four years of service, he will be vested in just 60% or 80% of the employer matching contributions to his plan, depending on how the employer counts a year of service.

Now let’s get into the details of how that comes about.

What Is 401(k) Vesting?

401(k) vesting simply refers to ownership of the funds within a retirement plan. Employee contributions to a retirement plan are always 100% vested.

This means the employee contributions belong solely and entirely to the employee. That’s as it should be, since the contributions are made from the employee’s own earnings.

But the question of 401(k) vesting enters the equation when an employer offers matching contributions to the plan.

Many employers do offer a plan match, and the specific terms vary with each plan. For example, one plan may offer to match 50% of the employee’s first 6% of salary contributions.

If the employee contributes 6% of his or her paycheck to the 401(k) plan, then the employer will match at up to 3% of the employee’s salary, for a total of 9%.

Other companies might match 100% of the employee’s contribution, up to say 8% or 10% of the employee’s salary.

It is that employer match and not the employee’s contribution to the plan, that is typically subject to 401(k) vesting provisions.

What Is a 401(k) Vesting Schedule?

There are various ways 401(k) vesting takes place. And exactly how it works mechanically depends upon the provisions within the retirement plan itself.

It is even possible for an employer to offer an immediate 100% vesting of all employer-matching contributions, though this is fairly rare.

More often, 401(k) vesting is subject to a vesting schedule. This schedule takes one of two forms, cliff vesting and graded vesting.

Cliff Vesting

Cliff vesting is pretty much what the term implies. That is, all of the vesting takes place at a certain point in the vesting schedule. For example, employer matching contributions may be entirely non-vested for the first two years that the employee participates in the program.

But after that two-year timeframe, the employee becomes 100% vested in year number three.

On the opposite end of the spectrum, once you clear the non-vested term, 100% of the employer match becomes vested with you as the sole owner of the funds.

Graded Vesting

Graded vesting is a process in which vesting takes place on a gradual basis. Under the graded method, 401(k) vesting takes place incrementally and over a period of several years.

Here’s an example of how graded vesting works:

• Year 1 of employment, 0% vesting

• Year 2 of employment, 20% vesting

• Year 3 of employment, 40% vesting

• Year 4 of employment, 60% vesting

• Year 5 of employment, 80% vesting

• Year 6 of employment, 100% vesting

Graded vesting has the advantage if you leave the employer after the first year of employment, but before the end of the second, you will at least have 20% of the matching contributions vested.

Graded vesting leaves you in a situation where your employer match has two parts – the vested portion and the non-vested portion. For example in the fourth year of employment, 60% of the employer match would be vested, and therefore fully owned by you.

However, the remaining 40% will continue to be owned by the employer. Since it represents non-vested funds, you will forfeit that amount in the event you leave the company – even though the balance will still show as being part of your 401(k) plan.

Fortunately, most 401(k) plan statements will break out your plan balance in three parts – your contributions to the plan (fully vested), the vested portion of employer matching contributions, and the non-vested portion of employer matching contributions.

Exceptions to 401(k) Vesting Rules

Though cliff vesting and graded vesting are the typical vesting schemes, there are two exceptions to the rule:

1. All employees must become 100% vested by the time they attain normal retirement age under the plan, or

2. When the retirement plan is terminated by the employer

That provides an obvious advantage to anyone who takes a new job shortly before retirement age.

In that situation, if you took a job with the company at age 62, and participated in its retirement plan – which set the retirement age at 65 – you would be 100% vested in the employer matching contributions upon turning 65.

This would of course also protect you in the event you are participating in a plan with an employer match, and the employer either terminated the plan or went out of business.

What Does It Take to Become 100% Vested?

In addition to requiring you to work a certain minimum number of years for the company, the employer can and usually does define the terms of that employment.

Within the plan, employers typically require a minimum number of hours worked in any year of participation. This is generally a minimum of 500 hours per year, but it could be as high as 1,000 hours per year.

In addition, some plans may count years of service in different ways. For example, a company could consider years of service based on your start date.

In that way, the exact years of service you would need to work would be unique to you, based on your hire date.

More typically, an employer will use calendar years. In that situation, they will count as a full year any year in which you have worked the minimum required number of hours.

For example, if they require 1,000 hours per year, and you were hired on May 1, the partial year would count toward your years of service as long as you completed at least 1,000 hours during that partial year.

These are just examples of typical 401(k) vesting requirements. The specific requirements will vary with each employer, as the IRS gives employers considerable leeway in determining the details of the retirement plan that they are sponsoring for their employees.

What Does It Mean to be “Fully Vested”?

In the simplest terms, being fully vested means you as the employee have full ownership of the funds in your retirement plan.

If you have met the requirements for vesting – whether the method is cliff investing or graded investing – and all funds within your retirement plan are fully owned by you.

This includes both your own employee contributions to the plan, as well as any and all employer matching contributions.

There are at least two major advantages to being fully vested:

• Terminating your employment.

Whether you leave your employer voluntarily, or you are fired, 100% of the funds in your retirement plan will come with you.

If you do leave the company, you are then free to roll the 401(k) proceeds over into a traditional IRA, convert the balance to a Roth IRA, or roll the plan over into the retirement plan of your next employer.

• Taking a loan against your retirement plan.

The IRS allows you to take loans of up to 50% of the vested balance of your retirement plan up to a maximum of $50,000. Naturally, the higher your 401(k) vesting is, the larger the loan amount you can take.

Since the IRS allows you to borrow up to 50% of your vested plan balance, you can take a loan for as much as $21,000. But if you are with the employer for at least six years, you would be fully vested in the plan.

That would enable you to borrow up to $25,000, which is equal to 50% of the total value of your 401(k) plan.

What if You Don’t Have Full 401(k) Vesting?

The short answer is you don’t have full ownership of your 401(k) plan balance.

No matter how much money your 401(k) plan may have, you only actually own the amount that represents your own contributions to the plan, as well as any amount of employer-matching contributions that have been vested.

But there are two important points to remember about 401(k) vesting.

The first is it’s found money. It’s always worth getting, but if you don’t get it – because you terminated your employment – you really haven’t lost anything either. But it’s usually worth staying with an employer to get full 401(k) vesting, especially if you’re just a year or two away from it.

The second point relates to the employer. Employers offer 401(k) plan contribution matches as an additional benefit to their employees. They are well aware of the fact that a good employer match provides a strong hiring incentive.

But since they are also anxious to minimize employee turnover, they use 401(k) vesting schedules to make sure their people stay around for a few years.

It works in both cases. As an employee, the employer match is a definite wealth enhancer. And from an employer standpoint, it’s a major reason why you are likely to stay with your employer for at least a few years.

And once you’re fully vested, it’s all yours. That’s one of the best retirement deals there is.

Final Thoughts on Ask GFC 032: How Does 401(k) Vesting Work

401(k) vesting often takes a backseat despite its significant implications. Vesting essentially signifies ownership of the funds within your retirement plan, especially employer contributions.

Vesting schedules, commonly categorized as a cliff or graded vesting, involve meeting specific criteria, including years of service and a minimum number of work hours annually. 

Full vesting offers distinct advantages, granting complete control over plan funds, facilitating smooth job transitions with rollovers or conversions, and enabling plan loans, albeit dependent on employer policies.

In contrast, partial vesting restricts access to vested employer contributions, emphasizing the importance of patience when approaching full vesting.

Employers, aware of the allure of generous matching contributions, utilize vesting schedules strategically to promote employee retention.