What Is Vesting?
Vesting (or a vesting schedule) requires employees to fulfill a specified term of employment to gain access to benefits, such as retirement funds. Vesting is a way for employers to keep top-performing employees at the company. When an employee is vested in employer-matching retirement funds like a 401(k) or stock options, they have nonforfeitable rights to those assets.
Key Takeaways
- Being vested gives an employee nonforfeitable rights to certain assets.
- Employee contributions to an employer-sponsored retirement plan are always considered 100% vested.
- A common vesting schedule is threetofive years.
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How Vesting Works
Employees commonly save a percentage of their paycheck into their 401(k)s, and their employer may match part or all of that contribution.Employees are always 100% vested in their salary-deferral contributions to their retirement plans.
Employer contributions to a 401(k) plan may vest immediately. However, a company may instead set up a vesting schedule to determine when employees acquire full ownership of the contributed portion. Matched dollars usually take several years to vest, meaning an employee must stay with the company long enough to be eligible to receive them.
Vesting within stock bonuses offers employers a valuable employee retention tool. For example, an employee might receive 100 restricted stock units as an annual bonus. To entice this valued employee to remain with the company for five years, the stock may vest according to the following schedule: 25 units in the second year after the bonus, 25 units in year three, 25 units in year four, and 25 units in year five. If the employee leaves the company after year three, only 50 units would be vested, and the other 50 would be forfeited.
Employee contributions to an employer-sponsored retirement plan are always considered 100% vested.
Types of Vesting
- Cliff Vesting Schedule: Gives the employee ownership of 100% of the employer’s contributions all at once after a certain number of years.
- Graded Vesting Schedule: Gives the employee ownership of a percentage of the employer’s contribution each year.
Traditional pension plans, for example, might have a five-year cliff vesting schedule or a three- to seven-year graded vesting schedule.
Although an employee may be fully vested in their employer’s contributions, it does not mean they can withdraw that money whenever they want. Employees are still subject to the plan’s rules, which generally require them to reach age 59 1/2 before making penalty-free withdrawals.
Where Is Vesting Used Besides Retirement Plans?
Vesting is common in wills and bequests and often takes the form of a set waiting period to finalize bequests following the testator's death.
What Does 3 Year Vesting Mean?
This means that after a period of three years, the employee will be fully (100%) vested in the assets in the account. These assets are typically the employer-matching contributions set aside for the employee.
What Is a Common Vesting Period?
A common vesting period is threetofive years, but the period is chosen by the employer.
Another common option is the graded vesting schedule. If the vesting were graded over a six-year period, after the first year, the employee would be vested in 0% of the assets. After the second year, the employee would be vested in 20% of the assets. After the third year, the employee would be vested in 40% of the assets. After the fourth year, the employee would be vested in 60% of the assets. After the fifth year, the employee would be vested in 80% of the assets. And finally, after the sixth year, the employee would be vested in 100% of the assets.
Why Would Employers Offer Stock Options on a Vested Schedule?
Startup companies often offer grants of common stock or access to an employee stock option plan to employees, service providers, vendors, board members, or other parties as part of their compensation. To encourage loyalty among employees and keep them engaged and focused on the company's success, such grants or options are subject to a vesting period during which they cannot be sold.
The Bottom Line
When an employee is vested in employer-matching retirement funds, they have nonforfeitable rights to those assets. Employers commonly require employees to work for the company for several years to become "vested."
