All About Vesting of Employer Contributions
Employers have flexibility in defining their plan’s vesting schedule, which can be an important employee retention tool.
Regardless of age, employees (as well as job seekers), are thinking about saving for their future. 401(k) plans, therefore, are a very attractive benefit and can be an important competitive tool in helping employers attract and retain talent. And when a company sweetens the 401(k) plan with a matching or profit sharing contribution, that’s like “free money” that can be hard for prospective and current employees to pass up.
But with employer contributions comes the concept of “vesting,” which both employees and employers should understand.
What is Vesting?
With respect to retirement plans, “vesting” simply means ownership. In other words, each employee will vest, or own, a portion or all of their account in the plan based on the plan’s vesting schedule. All 401(k) contributions that an employee makes to the plan, including pre-tax and/or Roth contributions made through payroll deduction, are immediately 100% vested. Those contributions were money earned by the employee as compensation, and so they are owned by the employee immediately and completely.
Employer contributions made to the plan, however, usually vest according to a plan-specific schedule (called a vesting schedule) which may require the employee to work a certain period of time to be fully vested or “own” those funds. Often ownership in employer contributions is made gradually over a number of years, which can be an effective retention tool by encouraging employees to stay long enough to vest in 100% of their employer contributions.
What is a 401(k) Vesting Schedule?
The 401(k) vesting schedule is the set of rules outlining how much and when employees are entitled to (some or all of) the employer contributions made to their accounts. Typically, the more years of service, the higher the vesting percentage.
Different Types of 401(k) Vesting Schedules
Employers have flexibility in determining the type and length of vesting schedule. The three types of vesting are:
- Immediate Vesting - This is very straight-forward in that the employee is immediately vested (or owns) 100% of employer contributions from the point of receipt. In this case, employees are not required to work a certain number of years to claim ownership of the employer contribution. An employee who was hired in the beginning of the month and received an employer matching contribution in his 401(k) account at the end of the month could leave the company the next day, along with the total amount in his account (employee plus employer contributions).
- Graded Vesting Schedule - Probably the most common schedule, vesting takes place in a gradual manner. At least 20% of the employer contributions must vest after two years of service and 100% vesting can be achieved after anywhere from two to six years to achieve 100% vesting. Popular graded vesting schedules include:
|3-Year Graded||4-Year Graded||5-Year Graded||6-Year Graded|
|Yrs of Service||% Vested||% Vested||% Vested||% Vested|
|0 - 1||33%||25%||20%||0%|
|1 - 2||66%||50%||40%||20%|
|2 - 3||100%||75%||60%||40%|
|3 - 4||100%||80%||60%|
|4 - 5||100%||80%|
|5 - 6||100%|
- Cliff Vesting Schedule - With a cliff vesting schedule, the entire employer contribution becomes 100% vested all at once, after a specific period of time. For example, if the company has a 3 year cliff vesting schedule and an employee leaves for a new job after two years, the employee would only be able to take the contributions they made to their 401(k) account; they wouldn’t have any ownership rights to any employer contributions that had been made on their behalf. The maximum number of years for a cliff schedule is 3 years. Popular cliff vesting schedules include:
|2-Year Cliff||3-Year Cliff|
|Yrs of Service||% Vested||% Vested|
|0 - 1||0%||0%|
|1 - 2||100%||0%|
|2 - 3||100%|
Frequently Asked Questions about Vesting
What is a typical vesting schedule?
Vesting schedules can vary for every plan. However, the most common type of vesting schedule is the graded schedule, where the employee will gradually vest over time depending on the years of service required.
Can we change our plan’s vesting schedule in the future?
Yes, with a word of caution. In order to apply to all employees, the vesting schedule can change only to one that is equally or more generous than the existing vesting schedule. Known as the anti-cutback rule, this prevents plan sponsors from taking away benefits that have already accrued to employees. For example, if a plan has a 4-year graded vesting schedule, it could not be amended to a 5- or 6-year graded vesting schedule (unless the plan is willing to maintain separate vesting schedules for new hires versus existing employees). The same plan could, however, amend its vesting schedule to a 3-year graded one, since the new benefit would be more generous than the previous one.
Since my plan doesn't currently offer employer contributions, I don't need to worry about defining a vesting schedule, right?
Whether or not your organization plans on making 401(k) employer contributions, for maximum flexibility, we recommend that all plans include provisions for discretionary employer contributions and a more restrictive vesting formula. The discretionary provision in no way obligates the employer to make contributions (the employer could decide each year whether to contribute or not, and how much). In addition, having a restrictive vesting schedule means that the vesting schedule could be amended easily in the future.
When does a vesting period begin?
Usually, a vesting period begins when an employee is hired so that even if the 401(k) plan is established years after an employee has started working at the company, all of the year(s) of service prior to the plan’s establishment will be counted towards their vesting. However, this is not always the case. The plan document may have been written such that the vesting period starts only after the plan has been in effect. This means that if an employee was hired prior to a 401(k) plan being established, the year(s) of service prior to the plan’s effective date will not be counted.
What are the methods of counting service for vesting?
Service for vesting can be calculated in two ways: hours of service or elapsed time. With the hours of service method, an employer can define 1,000 hours of service as a year of service so that an employee can earn a year of vesting service in as little as five or six months (assuming 190 hours worked per month). The employer must be diligent in tracking the hours worked to make sure vesting is calculated correctly for each employee and to avoid over-forfeiting or over-distributing employer contributions.
The challenges of tracking hours of service often lead employers to favor the elapsed time method. With this method, a year of vesting is calculated based on years from the employee’s date of hire. If an employee is still active 12 months from their date of hire, then they will be credited with one year of service toward vesting, regardless of the hours or days worked at the company.
If there is an eligibility requirement to be a part of the plan, does vesting start after an employee becomes an eligible participant in the plan?
Typically, no, but it is dependent on what has been written into the plan document. As stated previously, the vesting clock usually starts ticking when the employee is hired. An employee may not be able to join the plan because there’s a separate eligibility requirement that must be met (for example, 6 months of service), but the eligibility computation period is completely separate from the vesting period. The only instance where an ineligible participant may not start vesting from their date of hire is if the plan document excludes years of service of an employee who has not reached the age of 18.
How long does an employer have to deposit employer contributions to the 401(k) plan?
This is dependent on how the plan document is written. If the plan document is written for employer contributions to be made every pay period, then the plan sponsor must follow their fiduciary duty to make sure that the employer contribution is made on time. If the plan document is written so that the contribution can be made on an annual basis, then the employer can wait until the end of the year ( or even until the plan goes through their annual compliance testing) to wait for the contribution calculations to be received from their provider.
What happens to an employer contribution that is not vested?
If an employee leaves the company before they are fully vested, then the unvested portion (including associated earnings) will be “forfeited” and returned to the employer’s plan cash account, which can be used to fund future employer contributions or pay for plan expenses. For example, if a 401(k) plan has a 6-year graded vesting schedule and an employee terminates service after only 5 years, 80% of the employer contribution will belong to the employee, and the remaining 20% will be sent back to the employer when the employee initiates a distribution of their account.