Vesting: when employer contributions become yours

A 401(k) statement often shows two numbers: the account balance and the vested balance. The first is everything in the account. The second is the part that belongs to the employee no matter what. The gap between them, if there is one, is employer money the employee has not yet earned the right to keep.

What vesting means

The IRS puts it simply: "vesting" in a retirement plan means ownership. An employee who is 100% vested in an account balance owns all of it, and the employer cannot take it back for any reason.

Vesting applies differently to the two sources of money in the account.

• Employee contributions. Money an employee defers from their own pay is always 100% vested. That includes contributions made under automatic enrollment.
• Employer contributions. Matching and other employer contributions may be subject to a vesting schedule set by the plan document. Until the schedule is satisfied, some or all of that money can be forfeited if the employee leaves.

Investment gains follow the money that produced them. Earnings on employee contributions are fully vested; earnings on employer contributions vest on the same schedule as those contributions.

Cliff and graded schedules

Plans can vest employer contributions immediately, and some do. Where a schedule applies, it usually takes one of two forms.

Under cliff vesting, the employee owns none of the employer contributions until a set point, then owns all of them at once. Under graded vesting, ownership increases by a set percentage for each year of service.

The IRS describes the range of schedules a 401(k) or other defined contribution plan can use as running from immediate vesting, to 100% vesting after three years of service, to a schedule that increases the vested percentage with each year of service. The IRS page shows these two schedules:

A plan may be more generous than these schedules, for example vesting in equal steps over four years, but the plan document decides.

A worked example

Suppose, hypothetically, an employee has received $10,000 in matching contributions (including earnings) and the plan uses the six-year graded schedule above.

• Leaving after two years of service: 20% vested, so $2,000 of the employer money stays with the employee and $8,000 is forfeited.
• Leaving after four years: 60% vested, so $6,000 stays.
• Leaving after six years: 100% vested, so the full $10,000 stays.

Under a three-year cliff schedule, the same employee would keep nothing from the match if they left after two years and all of it after three. The employee's own contributions are unaffected in every case.

How a year of service is counted

A "year of service" is not always the same as a calendar year on the job. The IRS notes that it is defined by the plan, generally as 1,000 hours worked over a 12-month period, and that employers can choose different methods of counting service.

This can matter for part-time workers, for people who join or leave midyear, and for those close to a vesting date. In the IRS's example, an employee who started in June 2007 and quit in August 2011 was credited with five years of vesting service, because he worked at least 1,000 hours in each of five calendar years even though he was employed for a little over four years in total. A different plan with a different counting method might have reached a different result.

Because the details vary, a person close to a vesting milestone may find it useful to ask the plan administrator for their exact vesting service to date and the date the next step is reached.

When full vesting is required

Certain plan types and events require full vesting regardless of a schedule.

• Safe harbor and SIMPLE 401(k) plans. The IRS 401(k) overview explains that a safe harbor 401(k) generally must provide employer contributions that are fully vested when made, and a SIMPLE 401(k) carries the same requirement.
• SEP and SIMPLE IRA plans. All contributions to these IRA-based plans are always 100% vested.
• Normal retirement age. All employees must be 100% vested by the time they reach normal retirement age under the plan.
• Plan termination. If the employer terminates the plan, affected employees become fully vested.

What happens to unvested money

When someone leaves a job and is paid their account balance, the unvested portion is generally forfeited. The IRS also notes that unvested amounts may be forfeited when an employee does not work more than 500 hours in a year for five years. Forfeited money stays in the plan and is used according to the plan's terms.

The vested balance is the amount available to roll over, leave in the plan or withdraw. The guide to old 401(k) options describes those choices.

Where vesting shows up besides leaving a job

Vesting affects more than a final payout.

• Plan loans. The maximum loan is based on the vested balance, not the total. The IRS states the general limit as 50% of the vested account balance or $50,000, whichever is less. See 401(k) loans.
• Job decisions. The value of an employer match depends partly on how much of it an employee expects to keep. A departure date shortly before a vesting step can cost real money; shortly after one, it does not.
• Rehires. Someone who returns to a former employer may or may not get credit for earlier service. The rules on breaks in service are technical, and the plan administrator can say how they apply.

Finding a plan's schedule

The vesting schedule appears in the Summary Plan Description. The IRS suggests three places to look when questions come up: the employer or human resources department, the Summary Plan Description, and the annual benefits statement. Many plan websites also show the vested percentage and vested balance alongside the total.