One of the most confusing aspects of participating in an employer sponsored retirement plan is with understanding what percentage of the money is actually yours to keep. Namely, this idea of “vesting”.
Yes … believe it or not, not everything in your 401(k) is yours to keep! “How does 401(k) vesting work?” was one of the more complicated concepts for me to grasp.
I can still recall opening my first 401(k) statement and seeing two amounts: One for the total and one for the vested amount.
“Wait, what? … Why are there two amounts?” I thought.
Does this mean that some of the money I just put into my 401(k) isn’t really mine?
Fortunately, the answer to that question ended up being “no”. All the money I had contributed was of course mine.
But when it comes to employer matching (that awesome free money that your employer gives you simply for contributing to your own savings plan), the answer needed some interpretation.
Luckily, it’s not as nearly of a complicated concept as you might think. Here’s an easy to follow explanation of how 401(k) vesting works.
How Does 401(k) Vesting Actually Work?
To start, let’s take a look at how the IRS defines vesting:
“Vesting” in a retirement plan means ownership. This means that each employee will vest, or own, a certain percentage of their account in the plan each year. An employee who is 100% vested in his or her account balance owns 100% of it and the employer cannot forfeit, or take it back, for any reason. Amounts that are not vested may be forfeited by employees when they are paid their account balance.
In other words, it’s a schedule of terms setup by your employer that dictates when you technically own the 401(k) contributions that they have given you.
Notice that we’re only talking about the employer matching contributions. Your contributions, the money that you have personally invested into your 401(k) (plus any earnings) is always yours and yours to keep. In other words, you are always 100% vested in your own contributions.
Yes, the employer contributions that are often matched with 401(k) plans might not actually belong to you right away. Usually there is some amount of time you have to wait until they are yours.
Let’s break this down with a real-life example.
Graded Vesting Example:
My former employer had what’s called a “graded vestment” plan. This is where you start off the 401(k) plan being 0% for the first year.
At the beginning of the second year, your vesting level rises to 20%. Then in the third year, it rises again to 40%. It continues this process until your sixth year when you finally become 100% vested.
Here’s an example of what that looks like:
Had I left the company within the first few years for another job, then I’d forfeit some or all of my employer’s contributions (and any earnings they had made) up to date. All of that money would go back to my employer.
Since I stuck with the company for over six years, I became 100% vested. All of the contributions (and earnings) that my employer made were mine to keep; no matter if I left the company or not.
Are There Other Types of Vesting?
The graded vestment example I just gave is one common example. In reality, it’s up to the company to decide how employees get vested into their 401(k) plans.
A few other common ones include:
- Immediate. Just like it sounds. From the day you are hired, you are already 100% vested. All the 401(k) contributions are yours! This is the way my current employer handles vesting, and it’s great!
- Cliff. Cliff plans are when you are 0% vested for the first 1-2 years, and then immediately cross over into 100% vestment afterwards. It’s sort of an “all or nothing” schedule.
Year of Service
Typically with all vesting plans, your progress is measured in years of service with the company. In general this is usually defined as 1,000 hours of work (or more) for the year.
Why Are There 401(k) Vesting Rules?
Vesting can sound unnecessary complicated and sometimes like a raw-deal for the employee.
The truth is that the way vesting works is designed to benefit the employer.
Employers want a reason for employees to stay and be faithful to the company. Putting forth some type of vesting schedule provides some motivation for an employee to stick with the company rather than hop-ship after the next great job offer.
Of course, the opposite could be useful as well. Companies that grant immediate vesting as opposed to gradual, longer-schedule vesting will look more appealing to potential job seekers and those being recruited.
Can Vestment Rules Be Whatever the Employer Wants?
Yes, but know that there are some boundaries.
The Pension Protection Act of 2006 defined that an employee must be 100% vested after six or more years.
In addition, all employees must be 100% vested by the time they attain normal retirement age under the plan or when the plan is terminated.
What If I Have a SEP IRA or SIMPLE IRA Instead of a 401(k)?
If you happen to work someplace where your retirement plan is a SEP IRA or SIMPLE IRA, then you’re in luck. The IRS requires these types of plans to be 100% vested immediately.
No waiting around for you!
Readers – What are the vesting rules in your 401(k) plan?
Featured image courtesy of Flickr