When it comes to 401(k) vesting, a vested balance refers to how much of your contributions you already own. Contributions that employees make to their 401(k) accounts are always 100% vested; they own them outright. However, this may not be true of the money employers put into accounts. Those contributions may only belong to an employee after they’ve worked for the company for a certain amount of time. If someone were to leave their job before reaching that milestone, they could forfeit employer-contributed money that is not yet vested.
Here’s a deeper look at what being vested means and the effect it can have on your retirement savings.
401(k) Contributions Work Overview
Before you can understand vesting, it’s important to know how 401(k) contributions work. A 401(k) is an employer-sponsored retirement plan that allows employees to make elective deferrals of part of their salary on a pre-tax basis (they can choose how much of their salary to contribute from each pay period). As of 2020, employees can contribute up to $19,500 annually in their 401(k) accounts, with an extra $6,500 in catch-up contributions allowed for those who are age 50 or older.
The IRS also allows employers to contribute to their employees’ plans. Often these contributions are made in the form of a match. For example, an employer might offer matching contributions if an employee chooses to defer 6% of their salary.
As of 2020, the total contributions that an employee and employer can make to a 401(k) cannot exceed 100% of the employee’s salary or $57,000, whichever is less.
Employer contributions are a way for businesses to encourage their employees to save for retirement. They’re also an important benefit that job seekers look for when searching for new jobs.
What Is 401(k) Vesting?
The vested balance is the amount of money that belongs to you and cannot be taken back by an employer when you leave your job—even if you are fired.
Contributions that you make to your 401(k) are automatically 100% vested. Vesting of employer contributions typically occurs according to a set timeframe known as a vesting schedule. When employer contributions to a 401(k) become vested, it means that money is now fully yours.
At that point, an individual can decide to roll over their contributions to a new account or start taking withdrawals. Be mindful that withdrawals made before age 59 1/2 will be taxed and may be subject to early withdrawal penalties.
Whether a company contribution is vested will depend on what type of contribution it is. Contributions that are known as safe harbor matches are 100% vested when they are made. Employers may make these matching contributions only for employees who themselves make elective deferrals to their account. Or they can make contributions on behalf of all employees whether or not those employees make contributions themselves.
Matching contributions that do not fall under the safe harbor provision and profit sharing contributions may both be subject to a vesting schedule.
While contributions to traditional and Roth 401(k)s may be subject to vesting rules, that is not the case with SIMPLE 401(K)s. All contributions to these accounts are fully vested when they are made.
How Do I Know if I Am Fully Vested in my 401(k)?
Employees who are curious as to when they will be fully vested can check their plan’s vesting schedule. Employers can offer a variety of different vesting schedules. In addition to immediate vesting where employees own 100% of contributions right away, two common vesting schedules are cliff vesting and graded vesting.
Under a cliff vesting schedule, employer contributions are typically fully vested after three years of service. Federal law requires that 401(k) plans using a cliff vesting schedule wait no longer than three years for funds to be fully vested. A year of service is usually defined as 1,000 hours of work over a 12-month period.
Graded vesting is a bit more complicated. A percentage of contributions vest over the course of a set period of time, and employees gain gradual ownership of their funds. Eventually they will own 100% of the money in their account.
For example, a hypothetical six-year graded vesting schedule might look like this:
|Years of Service||Percent Vested|
All employees must be fully vested by the time they reach retirement age under the plan or if the plan is ever terminated.
Why Do Employers Use Vesting?
Offering 401(k) matching contributions is a benefit that employers may use to attract talented employees. Once an employee is hired, vesting is one way to dangle another carrot in front of them, encouraging them to stay with the company over the long term. Hiring and training new employees is a costly process for businesses. Withholding employer retirement contributions is a way to incentivize employees to stay at least as long as it takes for them to be fully vested.
Employees may want to take vesting schedules into account before getting a new job. If an employee is only one year away from being 100% vested, they may decide it’s worth waiting the extra time before leaving the company for another opportunity. But the decision is a personal one: For example, if a potential new position offers a much higher salary, an individual might do their own math and decide that the gains from the higher salary overshadow the losses of leaving a percentage of unvested funds on the table.
What Happens If I Leave My Job Before I’m Fully Vested?
If an employee leaves their job before being fully vested, they forfeit any unvested portion of their 401(k). How much money is left on the table will depend on your vesting schedule. For example, if the employer uses cliff vesting that vests after three years and the employee leaves the company before that time, they won’t receive any of the money their employer has contributed to their plan.
If, on the other hand, the employer uses a graded vesting schedule, the employee will receive any portion of the employer’s contributions that have vested by the time they leave. For example, if an employee is 20% vested each year over the course of six years, and they leave the company shortly after year three, they’ll be entitled to 40% of the employer’s contributions.
Other Common Types of Vesting
Aside from 401(k)s, employers may offer other forms of compensation that also follow vesting schedules, such as pensions and stock options. These tend to work a little bit differently than vested contributions. Stock options, for example, give employees the right to buy company stock at a set price and a later date, regardless of the stock’s current value. The idea is that between the time an employee is hired and their stock options vest, the stock price will have risen. The employee can then buy the stock and sell it to make a profit. With pensions, vesting schedules determine when an employee is eligible to receive their full benefit.
Both pensions and stock options may vest immediately or by following a cliff or graded vesting schedule.
How Do I Find Out More About Vesting?
There are a few ways to find out more about vesting and your own 401(k) vested balance. This information is typically included in the 401(k) summary plan description and/or the annual benefits statement.
Generally, the plan administrator or human resources department of a company is also able to explain the company’s vesting schedule in detail, and even pinpoint exactly where an employee is in their vesting schedule. Understanding this information can help an employee determine whether they want to look for a job now, or stick it out until they’re fully vested.
While any employee contributions to 401(k) plans are immediately fully vested, the same is not always true of employer contributions. These funds may be released to the employee slowly over time, or all at once after they’ve been employed by the company for a number of years.
Understanding vesting and your 401(k)’s vesting schedule is one more piece of information that can help you plan for your financial future. A 401(k) and other retirement accounts can be important components of a retirement savings plan. Knowing when you are fully vested in a 401(k) can help you understand how much money might be available to you when you retire.
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