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How Does Retirement Account Vesting Work?



As stated by the Internal Revenue Service (IRS), the term vesting is akin to saying "ownership." Having vested funds means that the individual account holder owns those funds. Similarly, an unvested portion of a retirement account is not yet fully owned by the plan holder, and therefore could be claimed by another party (e.g. the individual's employer).


Percentages are often attached to the term "vested"---e.g. 'she is 80% vested.' This means that of the funds that could fall under a vesting schedule, this participant owns 80% of them. The remaining 20% are still in limbo.


This article will describe how vesting works, what vesting maximums and minimums exist, and which investments can or cannot have a vesting schedule.


Can Vesting Apply to All Money in a Plan?


Vesting schedules can only apply to contributions made by the employer. The employee's contributions---e.g. 401(k) contributions through normal payroll deductions---are always 100% vested from the start. The employee owns that money from Day 1.


But employers are allowed to create vesting schedules for their contributions. If an employee leaves the company before the money is fully vested, the employer could "claw back" the unvested funds.


Typical Vesting Schedules


Two common vesting schedules are the cliff schedule and the graded schedule. The names themselves give away how these schedules work.


The cliff schedule is all-or-nothing. An employee spends their first two years of employment with 0% vested. If they quit, the employer could claw back all of the employer's 401(k) contributions. But when the "cliff" hits after the third year, the employee becomes 100% vested. All of the money in their 401(k) plan is now their own. The employer cannot touch it.


The graded schedule is gradual. With a 5-year graded schedule, the employee would attain, for example, 20% additional vesting for each year of employment. After 5 years, the employee's account would be 100% vested. If they quit after only 3 years, the employer contributions are only 60% vested. The employer can claw back the other 40%.


Vesting Maximums?


IRS regulations dictate that vesting periods can be anywhere from immediate to six years.


An immediate vesting period means that the employee is fully vested from Day 1. They own employer contributions the moment those dollars hit their retirement account.


A six-year vesting period means that some portion of the non-employee funds would not be fully vested until after six years of employment. The six-year graded schedule is illustrated below:


· After one year of service: 0% vested

· After two years of service: 20% vested

· After three years of service: 40% vested

· After four years of service: 60% vested

· After five years of service: 80%vested

· After six years of service: 100% vested


What Can/Cannot Have a Vesting Schedule?


In order for funds to fall under a vesting schedule, the following conditions must be true:


The funds must be employer contributions

The funds must be in a non-safe harbor plan. In other words, safe harbor plan funds are

always 100% vested.


Every other type of contribution must be immediately 100% vested. This can include employee contributions, rollover contributions, and employee after-tax contributions.


Does Anything Trigger Automatic Vesting?


Here is an example. Let us say an employee is halfway through a vesting schedule. Are there any outside actions that could automatically trigger full vesting? The answer is yes.


There are four events that can trigger automatic, 100% vesting.


These first three are non-optional. Employers must be 100% vested in all accounts if:


The company ends its retirement plan.

A participant reaches the "Normal Retirement Age" defined in the plan document.

A participant reaches the "Early Retirement Age" defined in the plan document (though not all

plans have an Early Retirement Age


The fourth event that can trigger 100% vesting is death or serious disability of the participant. This is not a required trigger but is commonly adopted by plans.


Summary


Vesting and vesting schedules allow employers to maintain some control over employer contributions. This can incentivize employee loyalty. But over time, vesting---or ownership---always occurs. It is in the interest of the plan administrators to understand how vesting works.