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Sunday, April 21, 2024

What is a vesting period?

What is a vesting period?

03.26.2024

Your vesting period is an important factor to consider in employer benefits because it determines when you own your retirement assets or equity compensation. In this article, we’ll cover the basics of vesting, as well as how to determine your vesting schedule.

What is vesting?

Vesting is the process through which employees gain ownership of their employer-sponsored retirement funds or equity compensation over time. Vesting rewards long-term employees and incentivizes employee retention.

It is a common practice for an employee to pay a percentage of their paycheck into their 401(k)s, and their employer may match part or all of that contribution. For example, an employer may match 50% of the first 6% of employee contributions, resulting in a total contribution of 9%: 6% from the employee, 3% from the employer. Ideally, you should contribute the amount to your 401(k) that will result in the maximum match from your employer. So, if you employer will match 50% of the first 6% of your contributions, elect to contribute 6% to get the full 3% from your employer – this is essentially “free money.”  

Read more: What is 401(k) matching and how does it work?

Vesting in practice

While any money an employee deposits into a 401(k) is theirs, employer contributions work differently. Employees only own their employer’s contributions once they meet a specified term of employment within the company and the funds become “vested.”

If someone is 100% vested, they have 100% ownership of their 401(k) assets — even amounts the employer contributed. If the employee changes jobs or retires, they do not have to forfeit any of the 401(k) assets.

However, if someone is only 50% vested, they only have 50% ownership of the assets in question. If they leave their job, they could potentially forfeit 50% of the matching dollars from the employer or equity grants.

Impact of vesting on employees

Vesting can encourage employees to remain at their current company for longer to capitalize on vested benefits, reducing employee turnover and encouraging longer job tenure. If an employee leaves before becoming fully vested, they may forfeit a portion of the employer’s contributions, resulting in a lower 401(k) balance.

Understanding how vesting works at your company is important because it can have a serious impact on your savings and may influence how long you decide to stay with your current employer. Check your employer’s 401(k) vesting schedule in your plan document, your benefits handbook, and/or annual benefits statement. While 401(k) plans commonly feature vesting periods, other retirement plans like SEP IRA and SIMPLE IRA often offer immediate vesting. If you’re unsure about how vesting works at your company, reach out to the HR department for further guidance.

Understanding vesting periods

The vesting period is the schedule over which you gain ownership of various benefits.

While many companies implement vesting periods, some do not. In cases without a vesting period, employer contributions become fully accessible to the employee immediately. However, withdrawal penalties may still apply if funds are accessed prematurely.

Common vesting periods are 3 to 5 years, but employers can choose a variety of different schedules, too. In addition to 401(k)s, Restricted stock units (RSUs) and stock options may also require vesting.

RSUs and stock options are commonly offered by employers as part of an incentive compensation structure. For example, someone may be granted 200 RSUs at hire or over certain intervals during their employment. However, they don't own the stock until the grants have vested.

Vesting schedule

The employee slowly gains ownership in the stock over a stipulated time period, typically in equal installments. Here’s an example of what a 5-year vesting schedule could look like:

  • 1 year after the grant: 20% ownership
  • 2 years after the grant: 40% ownership
  • 3 years after the grant: 60% ownership
  • 4 years after the grant: 80% ownership
  • 5 years after the grant: 100% ownership

If an employee leaves before the completion of the vesting period, they may only retain the portion of ownership corresponding to the elapsed time. For example. if the employee leaves in year two after the grant, they would only be able to take 40% of the stock with them while the rest would be forfeited. Vesting periods are designed to entice employees to stay with a company as long as possible. 

Read more: RSUs vs stock options: What’s the difference?

Understanding types of vesting schedules

A vesting schedule is an incentive program for employees that gives them benefits when they have contractually fulfilled a specified term of employment with the company. 

Employers can choose from several types of vesting schedules. Understanding which one you're dealing with helps you understand how your decisions might impact your retirement benefits or company stock. 

Immediate vesting

Immediate vesting occurs when there is no waiting period for full ownership. For example, with immediate vesting in your 401(k) plan, you can take all the money with you without forfeiting part of the employer match contributions if you leave your job. Pretty straightforward!

Graded vesting

Graded vesting refers to the slow accumulation of ownership rights over time. For example, if the vesting period is four years, you might earn 25% ownership rights every year.

Graded vesting schedule example

Years of service

Percentage vested

 1

 25%

 2

 50%

 3

 75%

 4

 100%

Obviously, immediate vesting is preferable for employees. It means you don't have to worry about waiting to be able to walk away from a job or otherwise transfer benefits without losing some of the value.  But graded vesting is more common because it acts as an incentive to keep you at the employer for longer. 

Cliff vesting

Cliff vesting1 can mean a few different things, but in general it means there’s a waiting period before something happens. As one example, if an RSU grant has a 3-year cliff with immediate vesting, you’ll need to work for the company for 3 years.  Once you hit that 3-year cliff, 100% of the RSU grant will vest and you become the owner of shares.  As another example, if your employer has a 1-year cliff for 401(k) matches with a graded 4-year vesting schedule afterwards, you need to work there for one year to hit the cliff, and afterwards 25% of your employer matches will vest per year.  So, if you leave the employer after two years, you’d be able to take 25% of the employer matches with you.

Cliff vesting schedule example

 Years of service

Percentage vested 

 1

 0%

 2

 25%

 3

 50%

 4

 75%

 5

 100%

Special considerations and triggers

There are some instances in which you may become fully vested without waiting out the entire vesting period. This typically occurs when there is a special consideration or trigger.

Retirement

A common trigger is retirement. Regardless of where you are in a vesting period, retirement at the appropriate age sometimes causes you to be 100% vested in 401(k) plans.

Plan termination

Full vesting might occur if the employer terminates the plan for reasons beyond the employees' control. Changes in plan providers can trigger full vesting for employees.

Stock options
Stock options provided as benefits or compensation may also come with trigger events. There might be a provision that creates a trigger event if the company is sold, or an initial public offering (IPO) occurs. In this case, the trigger event can cause employees to become fully vested in their stock options so that they receive some type of compensation upon the sale of the company or after it goes public.

The bottom line

Understanding the details of your compensation structure is vital for comprehensive financial planning. When you know the ins and outs of your benefits, you can:

  • Plan ahead for building wealth and strategize for long-term financial goals
  • Make informed decisions about your career trajectory and evaluate the financial implications of your choices
  • Navigate retirements plans and gain clarity on vesting schedules

To get the most out of your benefits, conduct thorough research on all the components of your compensation package. You can consult your company’s HR representative or a trusted financial professional for guidance.

1 IRS, “Retirement Topics - Vesting.”

RO3455193-0324

JJ Lester, CFP®

Contributor

JJ Lester is an Options and Real Estate Specialist at Empower. A CERTIFIED FINANCIAL PLANNER™ professional, he provides clients with robust planning advice on employer equity compensation and real estate investing.

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