What is Vesting?
"Vesting" refers to your portion of ownership in the money that has been given to you.
By law and by definition, you are always 100% vested in any money you contribute directly to your own retirement plan.
To encourage your loyalty, employers can make their contributions to your account subject to vesting schedules, which means they can dangle their contributions in front of you like a carrot -- the more years you work, the more of their contributions you get to keep.
Vesting Schedules for Retirement Accounts
Vesting schedules come in three basic types:
- Immediate vesting: Just as the name implies, employees with this type of vesting plan gain 100% ownership of their employer's matching money as soon as it lands in their accounts.
- Cliff vesting: Cliff vesting plans transfer 100% ownership to the employee in one big chunk after a specific period of service. Workers have no right to any of their matching contributions if they leave before that period expires. But the day they reach the landmark date, they own it all.
Federal law puts a three-year limit on cliff vesting schedules in qualified retirement plans, such as a 401(k) or a 403(b).
- Graded vesting: Graded vesting gives employees gradually increasing ownership of matching contributions as their length of service increases, resulting in 100% ownership.
For example, a five-year graded vesting schedule might grant 20% ownership after the first year, then 20% more each year until employees gain full ownership after five years. If they leave before five years are up, they get to keep only the percentage of their employer's matching contributions in which they are vested.
Federal law sets a six-year maximum on graded vesting schedules in retirement plans.
Stock options give employees the right to buy company stock at a set price, regardless of the stock's current market value. The hope is that the stock's market price will rise above the set price before the option is used, giving the employee a chance at a quick profit.
Stock option plans can come with any of the basic forms of vesting. In a cliff plan, all of the options offered to an employee become operable on the same date. In a graded plan, employees are allowed to exercise only a portion of their options at a time.
If employees, for example, are granted options on 100 shares with a five-year cliff vesting schedule, they must work for the company for five more years before they can exercise any of the options to buy shares. In a five-year graded schedule, they might be able to buy 20 shares per year until they reach 100 shares in the fifth year.
Because most stock option grants are not part of an employee's retirement plan, their vesting schedules are not limited by the same federal rules that govern matching contributions.