401(k) vesting schedules

It’s important to understand vesting schedules if your company’s 401(k) offers an employer contribution. With a match, the employer contributes up to a particular percentage of what the employee contributes. With profit sharing (also called a “non-elective” contribution), the employer contributes a discretionary percentage of an employee’s compensation regardless of participation in the plan.

But these funds don’t always immediately belong to an employee. Under the Employee Retirement Income Security Act (ERISA), employers may decide to delay the vesting, or earning, of their contributions to the employee. A vesting schedule, as outlined in the plan document, determines when employees earn employer funds. 

Let’s dive deeper into 401(k) vesting schedules below.

What is vesting?

“Vesting” refers to an employee’s ownership of employer funds contributed to their retirement account. While personal contributions to an employee’s 401(k) plan are immediately vested, employers aren’t required to offer immediate vesting of their contributions to employees. 

Once an employee does vest in their employer contributions, the employee has the right to keep those contributions—even when an employee terminates and regardless of the cause. 

Companies may choose when employees receive these employer contributions (more on this later). The IRS allows employers to impose a waiting period of up to six years on employer contributions. According to 2021 research from XpertHR, many employees wait several years before they receive full ownership of their matching funds. While 62% of employers offered full vesting within three years of employment, only 28% offered immediate vesting.

Differences between 401(k) vesting and 401(k) eligibility 

The difference between vesting and eligibility is the difference between an employee earning the right to keep a company’s contributions to their retirement account and the employee being able to participate in the 401(k) plan. Chronologically speaking, eligibility comes first.

Vesting: Vesting refers to the schedule by which the employee earns employer contributions (including matching contributions). A vesting schedule can be set to increase retention and promote longevity within a company. 

Eligibility: Eligibility is the criteria that identify who is allowed to participate in the 401(k) plan. For the same reason mentioned above, companies may not allow employees to enroll or make their own contributions until they meet certain minimum requirements. Read more about the basics of 401(k) plan eligibility.

Don’t confuse vesting and eligibility! For example, all employer contributions might vest immediately, but an employee might not be eligible to contribute to their 401(k) for the first six months of their employment.

Types of 401(k) vesting schedules

There are various company contributions with varied vesting schedules, all of which must follow Internal Revenue Code rules. 

Some companies offer immediate vesting of their matching contributions. Other plans have rules which vest employees in employer-contributed funds based on an incremental schedule. For example, an employer might require employees to work for a company for three years to vest. Or, the company can choose to have the 20% of the contributions vest yearly over five years. 

There are three common vesting options.

1. Full, immediate vesting (required for safe harbor contributions)

If your company offers a safe harbor provision or SIMPLE 401(k), the amount you contribute to employees must be immediately, 100% vested.

2. Cliff vesting schedule

Under a cliff vesting schedule, an employee isn’t vested in employer contributions until after a specified number of years of service, up to three, at which point the employee is 100% vested. Three years is the longest an employer can make an employee wait to be vested using a cliff schedule. 

3. Graded vesting schedule

With a graded vesting schedule based on the years of service, an employee keeps a portion of the money the company has contributed for up to six years. After six years of employment, all company contributions must belong to the employee. 

Below is a common graded vesting schedule:

Exceptions to vesting schedules

There are a few cases where a plan’s vesting schedule is overridden, and employees are granted full ownership of employer contributions. For example, employees must be 100% vested by reaching normal retirement age as defined by ERISA, or when the plan is terminated. In the case of a partial plan termination (20% or more turnover in an eligible workforce), affected participants must be fully vested.

401(k) vesting options for employers

Depending on the vesting plan an employer adopts, it can allow the company to entice candidates to join their organization with immediate vesting, or it can serve as a reward and incentive for employees to stay with the company for a period of time, using graded or cliff vesting. 

Using a vesting schedule requires more time and administrative calculation than offering immediate vesting. However, a cliff or graded vesting schedule may benefit employers who struggle with high turnover rates by encouraging employees to stay until they are fully vested.

Can an employer change their vesting schedule? 

The short answer is yes—an employer can change their vesting schedule. However, changes are subject to several regulatory restrictions. Before altering a plan’s vesting schedule, an employer should understand how proposed changes may affect participants, as well as how to calculate the correct vested percentage for participants after the change.

Any new vesting schedule will automatically apply to all participants with fewer than three years of service on the date the amendment becomes effective. Participants with three or more years of service on the effective date can choose the most beneficial vesting schedule (old or new). 

It is essential to review accounts for potential benefit decreases to employees, as ERISA’s anti-cutback rule states a benefit already earned by a participant cannot be removed. Changes in a vesting schedule should never result in a participant having a new, lower vested percentage than before the change. Because of the complexity of changing a vesting schedule, some recordkeepers (including Human Interest) do not support changes unless the schedule moves to immediate 100% vesting.

Should I make immediate vesting a part of my 401(k) plan?

When deciding whether to choose a vesting schedule or immediate vesting, consult with your legal, financial, and 401(k) advisors to help analyze the best option for your company. Be sure to consider the opinions of current and future employees in your decision-making process. If your 401(k) plan has what feels like an unreasonable or uncompetitive vesting schedule, employees may determine that the plan isn’t worth their participation. Or, they may opt to work for a company that provides immediate vesting or a schedule that better meets their retirement investment goals.

You're looking for vesting options for your business needs, budget, and goals. Whether you're a small business owner, or an HR director for a company with fifty employees, you want to make a sustainable vesting selection that provides a competitive advantage for your organization.

Human Interest offers options for vesting and eligibility. If you're looking for an affordable, flexible 401(k) for your employees, click here to signup for a demo today.