What does it mean to be vested in my 401(k)?
“Vesting” refers to ownership. Vesting has to do with how much of your 401(k) plan actually belongs to you.
For most companies, the longer you work, the more vested you are. Some may vest immediately, but most will drag it out over time.
In most cases where there is an employer match, there is a vesting schedule. It may require you to be employed with the company anywhere from two to five years (sometimes more) in order to become 100% vested.
If you are not fully vested, you could lose some of the employer contributions when you leave your job. But whatever you contributed is fully yours, plus any earnings your investment has gained.
If, on the other hand, you are fully vested, everything is yours, both your contributions (and any gains) and your employer's matching funds.
Generally speaking, if you leave your employer after only one or two years, you'll keep 100% of your contributions and perhaps some percentage of your employer's contributions.
If your employer doesn't provide a matching contribution, then vesting is not an issue in your plan. Everything in the plan is 100% vested, since it comes entirely from your own contributions.
Vesting becomes an issue only if the employer offers a match. And then it's a matter of how the vesting process takes place.
Employer matching contributions
Here's a likely scenario for an employer's contribution. They'll match 50% of your own contributions up to a maximum of, say, 3% of your salary. If you contribute 6% of your pay to the plan, the employer will make the full match at 3%. This means you have a total combined contribution of 9% of your salary.
Some plans are more generous, with the employer matching 100% up to a 10% contribution from you. In that situation, the combined contribution would be 20% of your salary.
Two types of 401(k) vesting schedules
401(k) plans have two different vesting schedules. They're referred to as cliff vesting and graded vesting. It's important to know which kind your employer is using.
Cliff vesting
It's called “cliff vesting,” because you go through a time when none of the employer match is vested to a certain date after which the entire amount is 100% vested.
If the employer has a cliff vesting schedule, there may be a two- or three-year waiting period during which none of the employer matches is vested. But at the end of year two (or three), the entire employer contribution amount is vested, as well as all subsequent employer matching contributions.
On the surface, it may sound as if cliff vesting is the preferred method. But should you leave your employer before the vesting point is reached, you will forfeit 100% of employer matching contributions.
Graded vesting
Graded vesting is probably the more common of the two vesting schedules. Under this method, vesting takes place gradually. A typical graded vesting schedule might look something like this:
- Year 1 of employment, 0% vested
- Year 2 of employment, 20% vested
- Year 3 of employment, 40% vested
- Year 4 of employment, 60% vested
- Year 5 of employment, 80% vested
- Year 6 of employment, 100% vested
Graded vesting takes longer than cliff vesting — in some cases much longer. However, if you leave your employment early, you'll be able to take at least some of the employer match with you. For example, based on the schedule above, if you leave your employer after two years, you would be entitled to 20% of the employer match.
It also results in two different vesting classifications while vesting is being phased in. For example, after year three, your 401(k) statement may show three different balances in your plan:
- Your contributions: 100% vested
- Employer vested matching contributions: 40% (of the match)
- Employer non-vested matching contributions: 60% (of the match)
Of course once you're fully vested in the plan, your statement will show just two contributions — yours and your employer's — both of which will be 100% vested.
Defining a “Year” for vesting purposes
The employer may also have specific requirements relating to the employment term. For example, the company may require that you be a full-time employee. Or they may require a certain minimum number of hours of work per year, such as 1,000 hours, which works out to around 20 hours per week.
There may also be differences in the way each year is calculated. For example, some employers base vesting on calendar years. In this case, if your start date is September 15, your years of service for vesting purposes may not start until January 1 of the following year. In that way, vesting is determined by full calendar years of employment.
Others may use your start date with the company, and still others may use your plan participation date. For example, it's common for employers to have a waiting period before you're able to participate in a 401(k) plan. A typical waiting period is 90 days. If you begin employment on March 15, and there's a 90-day waiting period, you may not be eligible to participate in the plan until June 13. They may further roll that over to July 1 as the start of a new month.
Worth noting: It's important to remember that, while the IRS has general guidelines pertaining to 401(k) plans, employers have a considerable amount of latitude in how they specifically manage it. That's why plan rules with one employer may be quite different from another employer's.
Exceptions to 401(k) vesting rules
Whether an employer uses cliff or graded vesting, there are two exceptions under which vesting is accelerated:
- All employees must become 100% vested by the time they attain normal retirement age under the plan, which is generally 65, or
- When the retirement plan is terminated by the employer
Even if the employer has a graded vesting schedule spanning six years, if you were to begin working for that employer at age 63, and 65 is the normal retirement age, you would automatically be 100% vested upon turning 65. And if you're hired after reaching normal retirement age, you would automatically be 100% vested in employer matching contributions as they are made.
The impact of vesting on 401(k) loans
Vesting is often overlooked when it comes to 401(k) loans. Under IRS regulations, the maximum amount a plan can permit as a loan is the lesser of:
- The greater of $10,000 or 50% of your vested account balance, or
- $50,000
In either case, the maximum loan amount is based on the vested balance, not the total balance of the plan.
If you have $100,000 in your 401(k) plan, and $30,000 represents non-vested employer matching contributions, the plan value for loan purposes will be $70,000. This means your maximum loan eligibility is $35,000 (50% of $70,000).
Does a vesting schedule mean the employer match isn't worth it?
Due to vesting schedules, you may think the employer matching contribution doesn't mean much. This will be especially true if the company has a six-year graded vesting schedule. If you're fairly new with the company, you may not see much value in the match. This will be particularly true in certain industries and job classifications where employee turnover is high. For example, if there's a six-year graded vesting schedule, and the average employee lasts only three or four years, the match may not seem all that attractive.
But it's always important to remember that an employer match is free money. You don't have to do anything to get it, other than remain employed with the company. And even if you leave before being fully vested, you should be able to retain at least some percentage of the matching contribution. However much you're able to take with you will be better than nothing at all.
Using the employer matching contribution to determine your own 401(k) contribution
The terms of an employer matching contribution should also have an impact on how much you contribute to a 401(k) plan.
As a general rule, you should always contribute as much as you can. This allows you to save for retirement and also provides a valuable tax break on the amount contributed. In fact, you can contribute up to $19,000 for 2019 or up to $25,000 if you're 50 or older. That's a lot of income tax deferral.
But even if you're early in your career and have other obligations — such as student loans — you should make every attempt to make the maximum contribution that will produce the maximum employer match.
If your employer offers a matching contribution of up to 50% of the first 6% you contribute — 3% — then your contribution should be at least 6% of your salary. That will give you a 9% total contribution rate. And should you stay with your employer long enough to be fully vested — even if you don't expect to make it that long — you'll be way ahead when that day comes.
If you're interested in taking more control over your 401(k) plan, check out Blooom. This advisory firm was created to help you monitor and maximize your 401(k).
