In this article in our series on the mechanics of 401(k) plans, we’ll be covering the concept of vesting. As with the other articles in the series, we’ll refer specifically to 401(k) plans throughout, but most of the provisions apply to all types of Qualified Retirement Plans (QRPs), which go by many names: 401(k), 403(b), 457, etc..
Vesting refers to the process by which the employer-contributed amounts in the 401(k) plan become the unencumbered property of the employee-participant in the plan. Vesting is based upon the tenure of the participant as an employee of the employer-sponsor of the plan.
Generally, when an employee first begins employment there is a period of time when the employer wishes to protect itself from the circumstance of the new employee’s leaving employment within a relatively short period of time. Vesting is one way that the employer can protect itself from handing over employer-matching funds from the 401(k) plan if the employee leaves the job very soon. Vesting can also apply to other employer-provided benefits such as a pension, profit-sharing plan, or stock purchase plan.
It is important to note that you are ALWAYS vested in the funds that you have deferred into the 401(k) plan. Vesting refers to employer-provided benefits.
Vesting can be done in three ways: immediate, cliff, or graded. Immediate vesting is just as the name implies – the employee is 100% vested in employer-provided amounts immediately, with no limitations. In this case, if the employee left the company immediately after his or her first paycheck where 401(k) amounts were contributed on his or her behalf, those amounts would be available to rollover into an IRA or other QRP right away.
Cliff vesting refers to a process where a specific period of time must pass, and after that time has passed the employee is 100% vested in the employer-provided amounts. Until that time period has passed, the employee has a zero percent claim to the employer-provided amounts in the plan. Federal law prescribes a 3-year limit on cliff vesting schedules for QRPs – any length of time less than or equal to 3 years can be an applicable cliff vesting schedule.
Graded vesting refers to a process where a series of time periods pass, and after each of these periods of time a portion of the employer-provided amounts in the 401(k) plan becomes the property of the employee. Gradually the employee gains 100% vesting (access) to the employer-provided amounts. An example of a 4-year vesting schedule would provide vesting of 25% per year at the end of each of the four years. After the end of the first year of employment, 25% of the employer-matching funds are vested. After two years, 50%; after three years, 75%; and after the fourth year the funds are 100% vested with the employee. Federal law puts a limit of 6 years as the maximum number of years a vesting schedule can run.