What is vesting?

Answer:

Vesting occurs when an employee acquires ownership. Does an employer offer a retirement savings plan such as a 401(k), traditional pension, or profit-sharing plan? Do they distribute a stock option grant as a year-end bonus? These employee benefits and others like them are often tied to a timeline known as a vesting schedule. The vesting schedule determines when an employee acquires full ownership of the benefit.

For example, an employer grants an employee 10,000 stock options as a thank-you for a job well done. But it may not be time to go mansion shopping just yet. The options may not actually be distributed to an employee until they're vested. If the options are subject to a vesting schedule, the employee won't actually own the right to exercise their options until some time in the future. Some stock option plans allow for immediate vesting, while others may delay vesting. Consider these three alternatives for a four-year vesting schedule:

  • 25 percent each year
  • 50 percent in years two and four
  • 100 percent in year four

In addition, there are two permissible vesting schedules for employer contributions to most 401(k) and other defined contribution plans:

  • Cliff vesting: This provides no vested benefit until the third year. After three years of employment, you reach the "edge of the cliff," or vest 100 percent.
  • Graded vesting: This provides no vested benefit until year two. For each additional year that an employee remains with their employer, the benefits vest 20 percent each year. Under this schedule, an employee will be 100 percent vested if they remain with their employer for six years.

Keep in mind that if an employer follows the 100 percent in year-three vesting schedule, an employee will need to stay with their employer for three years before they are vested. Of course, any personal contributions that an employee makes to their employer's savings plan are automatically fully vested and remain theirs no matter how long they stay with the employer.

Defined benefit (traditional pension) plans can have a five year cliff vesting schedule, or a three to seven year graded schedule.

Keep in mind that an employer's plan can provide for faster (earlier) vesting than the law requires. And in some cases, faster vesting is required by law (for example, employer contributions to a SEP, SIMPLE IRA, or SIMPLE 401(k) plan must be immediately vested). To find out about a specific plan's vesting schedule, check with a manager or human resources representative, or read the summary plan description.

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