What does 401k vesting mean?

If your employer offers a company match, you can max out your contributions with the free money. Usually, employers may offer stock options, stock awards, and matching contributions to attract talented employees. However, it is not in the best interest of an employer to offer these benefits only for employees to leave the company for other companies. Hence, employers set up vesting guidelines so that employees do not fully own the employer’s benefits until after a specific period in the future.

401k vesting refers to the ownership of the 401(k) funds. Generally, if the employer contributes to your 401(k), you cannot claim the money until you have completed a specific period known as the vesting period. Once you are fully vested, you have the freedom to decide what to do with the money; you can cash out, take a distribution, or rollover to another retirement account.

What is 401(k) vesting?

401(k) vesting refers to the process by which you legally own the employer’s contributions in your 401(k) account. Some employers offer immediate vesting, where you fully own the employer's contributions right away. However, most employers have a vesting schedule that is spread over several years, and this determines when you acquire full control and ownership of the retirement assets.

For example, if a company has a vesting schedule of three years, it means you will be fully vested at the end of the three years. If you decide to leave the company on your third employment anniversary, you will fully own the employer's contributions in your account. You can then decide to cash out your 401(k), rollover to an IRA, transfer the 401(k) money to a new employer’s 401(k).

Types of Vesting Schedules

The following are the main types of vesting schedules that employers use:

Immediate vesting

If your employer offers immediate vesting, it means you are 100% vested in your employer’s contributions. If you decide to leave the company at any time, you will keep all employer contributions in your 401(k) account.

Graded vesting

This form of vesting means that a percentage of the employer's contributions vest over a specific period. The employee gains gradual ownership of the employer's contributions during the vesting period. The most common form of graded vesting is where 20% of the employer's contributions become vested each year starting from the second year until it is 100% vested. This means that if you leave the company after the third year, you will keep 40% of the employer's contributions.

Cliff Vesting

With cliff vesting, the 401(k) contributions become fully vested after a specific timeframe. For example, if a company sets the vesting time to three years, you will only become fully vested after the third anniversary of your service with the company. If you quit the job in the second year, you will lose all the employer’s contributions in your 401(k) account. Cliff vesting does not happen gradually; instead, you become fully vested after the lapse of the specified period.

Why do employers use vesting?

Once employees have been hired, employers use a vesting schedule to encourage employees to stay in the company for as long as it takes to get the most financial benefit. Without a vesting schedule in place, employees may quit the company for other entities in the market, and the employer will incur additional costs to recruit, hire, and train new employees.

If you are hunting for a new job, you should consider the vesting schedule of the company before leaving. If you are a few months away from being fully vested, it is worth waiting a few more months to gain the maximum benefit before leaving for another employer. However, if you are getting a pay rise in your new job, you should consider if you are willing to lose the unvested employer’s contributions for the higher paycheck.

What happens if you leave your employer before you are fully vested?

If you quit your job before you are fully vested, you forfeit any unvested portion of your 401(k) balance. The amount you forfeit will depend on the company's vesting schedule and the amount of the employer's contributions.

For example, if the company has a graded vesting schedule that increases by 20% every year starting from the second year, you will have to work for the employer for 6 years to be fully vested. If you leave the company in the third year, you will be 40% vested, meaning that you will forfeit 60% of the employer’s contributions.

On the other hand, if the employer uses a cliff vesting schedule over a three-year period, it means you will have to work in the company for at least three years to be fully vested. If you leave the company before this period expires, you will lose all the employer’s contributions deposited in your 401(k) plan.