If you are saving up money for your retirement, it is important that you consider the 401(k) plan offered by your employer as the first step in securing your future. 401(k) plans provide a 50% to 100% return on your investment. You are not likely to find another deal better than this anywhere else. There may be other retirement savings plans at your disposal, but this particular retirement plan should be your priority. However, there is a catch that most people usually ignore when it comes to 401(k) plans: Vesting.
What is 401(k) vesting?
Whenever you contribute money to your retirement account, your employer is expected to match this contribution. It is the reason why the 401(k) plan is a popular and lucrative option for most employees. However, the amount of money your employer contributes as a match may not be entirely yours right away. There is usually a definite period before which you can gain full ownership of the funds. In a retirement plan, vesting refers to ownership. It relates to a point in time where you can voluntarily leave or get fired by your employer but still get to retain the funds in your account.
However, vesting does not apply to funds that you directly contribute from your salary. You will own 100% of all contributions that are deducted from your pay and remitted to the retirement plan. The same case applies to SEP and simple contributions that your employer may make. It means that you are entitled to all the contributions you make regardless of the amount of time you have worked under your current employer.
What does vested mean?
The term vested is used to describe the sum of money that you own at a particular point in time, and which you are allowed to leave with should you voluntarily leave or get fired from your job. If the amount of money in your account is not vested, it is not considered yours at the time. And you can’t, therefore, take it with you when you leave.
How does 401(k) vesting work?
As I have stipulated above, you own 100% of the money you directly contribute from your salary. But in 401(k) vesting, you need to have worked for your employer for a specified period before you can own 100% of the matched contributions made by your employer.
For instance, your company’s policy might stipulate that only 20% of the contribution it makes to your retirement plan is vested each year. It would mean that you would not be entitled to any amount were you to leave before a year lapses. If you leave after a year, you will own 20% of the total value of these contributions. After two years, the amount will increase to 40%. To get the entire amount of matched contributions, you need to have worked for your employer for five years.
It is important to note that there are no separate time frames for each contribution. The vesting clock is similar in all contributions made by the employer. Whenever you become 100% vested, all the matches instantly become 100% vested regardless of the time they were made. It also applies to all contributions made in the future.
It might take a whole year before you can own a portion of the contributions made by your employer and five years before you can own it 100%. How much you own at what time will depend on the employer’s vesting schedule.
What is Immediate Vesting?
In 2015, about 40 percent of companies allowed matching contributions to vest immediately. In this case, the employee owns 100% of their account balance, which includes their contributions and the contributions matched by the employers. If your company allows immediate vesting, you can leave your job today and still own 100% of the contributions you made yesterday and those matched by your employer.
In yet another situation, the employee can allow you to vest 100% of the contributions they match if the company utilizes a “safe harbor” match. However, if your employer does not permit immediate vesting, it is because their vesting schedules do not allow it.
What are Vesting Schedules?
Although some companies allow for immediate vesting, it is not a common occurrence among most employers. Many of them will only allow you to vest according to the rules set out in their pre-determined schedule. Most rules will demand that you work for the company for a specified amount of time before you can begin to vest. It means that you can’t quit today and necessarily expect to get the matching contributions you got yesterday. There are two common types of vesting schedules.
1. Graded Vesting Schedule
In a graded vesting schedule, the percentage of the employer’s matched contributions that you vest will increase after every year of your employment. The company is allowed to use their preferred graded vesting schedule at their discretion. But the Pension Protection Act of 2006 prevents them from going lower than the following:
- 0% vested after one year of employment
- 20% vested after two years of employment
- 40% vested after three years of employment
- 60% vested after four years in employment
- 80% vested after five years of employment and
- 100% vested after six or more years in employment
2. Cliff Vesting Schedule
Just like the name appears to suggest, a cliff vesting schedule will not allow you to vest for a certain specified period. After the time lapses, you immediately become 100% vested just like going off a cliff. It will also be up to the employee to decide on the cliff vesting schedule, but the law stipulates that it should at least happen as fast as the following:
- 0% vested after one year of employment
- 0% vested after two years of employment
- 100% vested after three or more years of employment.
Every employer that offers to match your contributions will either adopt a graded vesting schedule or a cliff vesting schedule. They can’t use both.
What it means to be in a fully vested in a Plan
To be fully vested means that you own 100% of all the funds in your retirement account. It usually happens when the vesting period ends. In this case, you have complied with all the conditions set out by your employer. And they can’t, therefore, deny you access to your money for whatever reason.
Although the companies are at liberty to determine their vesting schedules, the IRS requires that all employees be vested fully after they attain their normal retirement age or when the employer decides to end the retirement plan. A company may choose to terminate the plan if they intend to change to another plan or if they are mandated by law to file for bankruptcy.
Being fully vested, however, does not exempt you from certain rules especially those that determine how you can withdraw money from the retirement plan account. For example, you are likely to attract penalties if you try to withdraw money before attaining the retirement age or before a specified deadline. The advantages of being 100% vested include the following;
Terminating your employment
It doesn’t matter whether you leave you current employ by your volition or after being fired; all the money in your retirement plan account leaves with you. There are three options that you can explore in this case: You can put all your proceeds into a traditional IRA, you can convert it to a Roth IRA, or you can carry the plan over into your next employer’s retirement plan.
Taking a loan against your retirement plan
The IRS permits you to acquire loans against the vested amount. You can acquire up to 50% of the funds vested in your retirement plan with a maximum cap of $50, 000. The sum of money you can get will be dependent on the vested funds in your 401(k).
For instance, let’s assume you have $50,000 in your retirement plan, which includes $30, 000 direct contributions and $20,000 employer contributions. If you have been employed for four years by a company that uses graded vesting, 60% of your employer’s contribution is vested. It means that the total vested amount is $30, 000 plus 60% of the $20,000.
Following the IRS guidelines, you can only borrow 50% of the vested balance, which is $21, 000 in this case. However, if you have been an employee for six years, you would be able to borrow $25, 000 since 100% of the amount has been vested. It is also important to note that although the IRS allows the employer to provide you with a loan against your retirement plan, it is not mandatory that they do so.
What does it takes to Become 100% Vested?
Vesting is a type of security feature for companies to retain talented and hardworking employees for the longer term. 401k vesting is the amount of time you MUST work for a company to fully accrue your 401k savings and not forfeit them (if you quit your job prematurely). Thus, when you are “fully vested”, this means you have accrued your 401k retirement savings fully and can rollover into an IRA incase you quit working for the company.
If you are the only one making contributions towards a 401k plan (and not your employer together), then you have full 100% vesting. However if your employer matches your 401k contributions by say 50% (meaning if you contribute $10000 a year into your 401k, your employer would therefore contribute 50% of $10,000 = $5000), then you might be required to perform a minimum certain # of years of work for your employer before you have 100% vesting of 401k retirement funds.
Here is a 401k Vesting Schedule set by the employee retirement Income Security Act (ERISA) as a minimum guideline both for 401k contributors and employers.
The # of years you have vested starts counting even before you start contributing towards a 401k plan. Thus for example if you have been working for your company for 7 years, but you just starting contributing towards a 401k plan 2 years ago, then 100% of your accrued benefits is vested (because you have worked for 7 full years – check the schedules above).
Thus, if you join a company that offers 401k plans, be sure to note down some important reminders:
- The day you started working for the company (hire date)
- The date you started contributing towards a 401k plan
- Any absence or leave that will be deducted of your # of years vested
Also note that if your employer changes the vesting schedule after you’ve accumulated 3 years of vested work for the company, you are NOT required to follow the new vesting schedules – you can stick to the old one, it’s your right!
Apart from the requirement that demands that you work for a specific number of years before becoming vested, there are other conditions that the company can set out within the plan. For example, most employers require employees to work for a minimum set of hours in a year. Workers are usually needed to bill 500 hours every year, but some companies can still go as high as 1,000.
Additionally, some retirement plans may choose to count the years differently. For example, the company can decide to start the count from the specific date the employee starts working. In this case, every worker will have unique years of service depending on the time they were hired.
In most cases, however, the employer uses calendar years. A year will only be counted, then, if you have worked for the minimum amount of hours required for that year. For instance, if you need 1000 hours every year and you joined the company in May, the year will only be considered in the final tally if work done in the remaining months constitutes 1,000 hours.
What happens when you don’t Have Full 401(k) Vesting?
If you don’t have full 401(k) vesting, it follows that you will not own the entire amount in your retirement plan. You will only be entitled to the amount you contributed directly, and your employer’s matched contributions that are vested.
There are two crucial points that you should always remember about vesting. The first is that the money was never yours to begin with. When you terminate your employment and fail to get the matched contributions that weren’t vested, you have lost nothing. However, staying for an extra one or two years to benefit from full vesting is usually worth it.
The second point touches on the employer. The contribution matches are an added advantage to the worker. The company is acutely aware that offering a favorable contribution match to the employee is a strong hiring incentive. But because they intend to reduce the chances of workers leaving their jobs, they must apply vesting schedules to ensure that they stay around for a little bit longer.
The plan benefits both parties. For the employee, the match contributions offer a retirement cushion that they can immediately own after it is fully vested. To the employer, it ensures that the workers stay in their jobs for at least a couple of years.
Should you invest in other retirement accounts?
When should you consider investing in other retirement plans at the expense your employer’s 401(k) plan? Rarely will you find investing in other retirement accounts to be more beneficial than the 401(k) plan.
Let’s assume a case where your employer may adopt a relatively stingy contributing policy by only matching 50% of all your contributions. If the contributions only vest 20% each year, you will earn a return on your investment of 10%. It is favorably good considering that investing in the stock market will only give you long-term returns to the tune of 7% to 8%.
Let’s also assume you choose to leave the company after working for less than one year. It would mean that you are not entitled to any match. However, you would still enjoy all the tax benefits of the 401(k) plan. Even in the worst-case scenario, the situation is not all that bad.
However, there are specific instances where you would consider saving you money elsewhere. For example, there IRS permits companies to start vesting contributions after three years in a cliff vesting plan. If your employer adopts this policy and you don’t intend to work for them for three years, you can choose to prioritize an IRA or health savings account before having a 401(k) plan.
You can decide to factor in your vesting schedule whenever you are deciding whether to change employees. But it should definitely not be the driving factor. However, if staying a little bit longer can significantly increase your vested percentage, it would not hurt to wait for a couple of months.
How to Find Your 401(k) Vesting Schedule
The easiest way to know your employer has a vesting schedule is to consult with your human resource department and ask for a copy of the 401(k) summary plan. Check the company policy as spelt out in the vesting section. You could even find that you are already 100% vested in all the matched contributions by the enterprise.
If you still have questions, you can seek clarification from the HR representative. If you want to know how far along you are as far as the vesting schedule is concerned, you can enquire about the date you officially started working.
Another important document that you can use to gather useful information is your latest 401(k) statement. It should indicate how much of the employee’s contribution makes up your 401(k) balance. You can multiply that number by the vested percentage you currently have to know how much money you actually own in the retirement account.
For example, if the balance in your retirement account is $40, 000, $10, 000 of that amount is what the company contributed, and you are only 40% vested. It means that you own 100% of $30, 000 since it is your contribution but only $4, 000 of the $10,000 because the company’s matched contributions are partly vested at this point.
What should you do when you Plan on leaving?
Signing up for the 401(k) retirement plan may not hurt although you may not be planning to stay in your current place of employment for a period long enough to be fully vested. In fact, you will find that most people end up staying in the present employ longer than they may have expected or planned. In this case, you may get to keep some of the retirement money. In cases where you are not sure of your future, choosing to save is the best option.
The importance of saving for retirement cannot be overemphasized. 401(K) plan is one of the most valuable retirement plans. However, make sure you familiarize yourself with your current employer’s vesting schedule before you can make any fundamental decisions. Having knowledge of your company’s vesting policies is crucial if you intend to take advantage of their offers and may want to become fully invested in future. You should also consider the vested contributions before you decide to switch employers.