We talk a lot about retirement plans here on Good Financial Cents, but one part of the retirement subject we don’t discuss enough is 401(k) vesting.
Not all plans have it, but many do. And some have very generous employer matches, making the question of 401(k) vesting an important one.
An Ask GFC reader asked the following question:
”I am a 401 k Plan participant which has a graded vesting schedule of 6 years. I have completed 4 years and am not working with the company since 2005. I am 55 years old. Am I 100% vested for employer's contribution?
I’m going to jump right to the answer to the reader's question, and I’ll explain the details of that answer as we go along.
Since the reader was in a plan that had a graded vesting schedule of six years, and he only completed four years of service, he will be vested in just 60% or 80% of the employer matching contributions to his plan, depending on how the employer counts a year of service.
Now let’s get into the details of how that comes about.
What is 401(k) Vesting?
401(k) vesting simply refers to ownership of the funds within a retirement plan. Employee contributions to a retirement plan are always 100% vested. This means the employee contributions belong solely and entirely to the employee. That’s as it should be, since the contributions are made from the employee’s own earnings.
But the question of 401(k) vesting enters the equation when an employer offers matching contributions to the plan.
Many employers do offer a plan match, and the specific terms vary with each plan. For example, one plan may offer to match 50% of the employee's first 6% of salary contributions. If the employee contributes 6% of his or her paycheck to the 401(k) plan, then the employer will match at up to 3% of the employee’s salary, for a total of 9%.
Other companies might match 100% of the employee’s contribution, up to say 8% or 10% of the employee’s salary.
It is that employer match, and not the employee’s contribution to the plan, that is typically subject to 401(k) vesting provisions.
What is a 401(k) Vesting Schedule?
There are various ways 401(k) vesting takes place. And exactly how it works mechanically depends upon the provisions within the retirement plan itself. It is even possible for an employer to offer immediate 100% vesting of all employer matching contributions, though this is fairly rare.
More often, 401(k) vesting is subject to a vesting schedule. This schedule takes one of two forms, cliff vesting and graded vesting.
Cliff vesting is pretty much what the term implies. That is, all of the vesting takes place at a certain point in the vesting schedule. For example, employer matching contributions may be entirely non-vested for the first two years that the employee participates in the program. But after that two-year timeframe, the employee becomes 100% vested in year number three.
The opposite end of the spectrum, once you clear the non-vested term, 100% of the employer match becomes vested with you as the sole owner of the funds.
Graded vesting is a process in which vesting takes place on a gradual basis. Under the graded method, 401(k) vesting takes place incrementally and over a period of several years.