Here's What It Means to Be Vested in Your 401(k)

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One of the biggest advantages to a 401(k) plan is having an employer that offers a match on your contributions. This is fairly common practice; in a review of 4.4 million retirement plan participants, Vanguard found that 94 percent of plans offered employer contributions.

Knowing that your employer is contributing or matching your contributions to your workplace retirement plan is awesome (who doesn't like free money?). Still, it's important to be aware that sometimes part of those contributions aren't fully yours until some conditions are met. That's called vesting.

What's vesting?

Let's get one thing clear: All of the money that you personally contribute to your retirement account always becomes immediately yours. When you have full ownership of funds in your 401(k), it means that you're fully vested (or 100 percent vested) on those funds.

On the other hand, employer contributions and matching contributions may be subject to some restrictions before they can become fully vested. Nearly half all employer-sponsored 401(k) holders are in plans with some type of vesting requirement for employer and matching contributions. All vesting schedules can be categorized as cliff or graded vesting. (See also: 7 Things You Should Know About Your 401(k) Match)

Graded vesting

Graded vesting is the most common way for employers to delay ownership of employer or matching contributions. Through graded vesting, you gradually gain ownership of employer or matching contributions over time. Around 30 percent of 401(k) plans with employer-matching contributions use a five- or six-year graded vesting schedule. For example, an employer could grant you 20 percent ownership over a five-year period. Assuming a $1,000 matching contribution, you would be fully vested to $200 (plus applicable capital gains) at the end of every year over a five-year period.

However, there are shorter (and longer!) graded vesting schedules. For example, an estimated 5 percent and 3 percent of 401(k) holders are in a plan with a three- and four-year graded vesting rule for employer matching contributions, respectively.

Cliff vesting

Unlike graded vesting, cliff vesting grants you full ownership of employer contributions to your account right away. The catch is that you have to wait a certain amount of time to gain that right. In 2016, 12 percent, 5 percent, and 8 percent of 401(k) plans followed a three-year, two-year and one-year cliff vesting schedule for employer contributions, respectively.

5 FAQs about vesting

Now that you know what it means to be vested in your 401(k), let's address some frequently asked questions about vesting.

1. Why do companies use vesting in 401(k) plans?

Workplace plans offer matching 401(k) contributions to attract top talent. In order to retain that talent, employers can use vesting to discourage leaving the company too soon. For example, with a three-year cliff vesting schedule, a worker would have to work that many years before becoming fully vested in all employer contributions from their first year of employment.

However, more and more plans are opting to provide immediate vesting: 45 percent of 401(k) plans provided immediate vesting of employer contributions in 2016. (See also: 8 Critical 401(k) Questions You Need to Ask Your Employer)

2. What happens with nonvested funds at the time of a rollover?

Once you leave your employer, you'll lose nonvested funds in your 401(k). This is why knowing the applicable vesting schedule is essential to know how much of your 401(k) you'd keep if you were to separate from your employer at any point in time.

When you separate from your employer, nonvested funds in your 401(k) return to your employer. So, keep an eye on when employer contributions become fully vested to appropriately time turning in your two-week notice. (See also: A Simple Guide to Rolling Over All of Your 401(k)s and IRAs)

3. What happens to nonvested funds when I retire?

There is some good news and some bad news. The good news is that according to the IRS, it is required that employees are 100 percent vested of all 401(k) employer contributions by the time they attain normal retirement age. The bad news is that the normal retirement age is determined by the plan administrator.

4. What happens to nonvested funds if my company disappears?

When a company goes kaput, it's just a matter of time until its 401(k) goes away as well. When a company terminates its 401(k) plan, it must offer 100 percent vesting of all funds, according to the IRS.

5. If vesting exists, why should I bother trying to get an employer match?

Getting those employer contributions is absolutely worth it because they don't count toward your annual contribution limit ($18,500 in 2018). You can't be 100 percent sure when you'll leave an employer, but you'll surely be happy if you can leave with a couple hundred or thousand dollars extra in your 401(k). Regardless of vesting rules, this is why pursuing a job that offers matching contributions is worth it.

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