Understanding 401k Vesting Rules

Do you understand 401k vesting rules? If you participate in some type of an employer sponsored retirement plan, you’ve likely heard the term vesting before, but maybe don’t know a lot about it. Here, we’ll get down to the nitty-gritty and explain the 401k vesting rules you need to know.

First, what does vesting mean?

Quite simply, vesting refers to the percentage of ownership you maintain over employer contributions in an employer sponsored plan. So, if you know you are 60% vested that means that you own 60% of all employer contributions in your account. If you happen to separate from service, you can take that 60% with you. The other 40% will be forfeited from your account and returned to the plan.

Note: It’s worthwhile to mention here that this only applies to employer contributions. Employee contributions are always 100% vested, of course.

Second, it’s important to know that 401k vesting rules are always based on schedules. The schedules dictate how much of the employer contribution you are entitled to based upon your years of service with your employer. The vesting schedule that your employer uses is spelled out in the plan document (the legal document your employer has that gives all the rules of the plan).

Third, you need to know that there are two general types of vesting schedules that an employer can use: Cliff vesting and Graded vesting schedules.

Cliff vesting means that for the first couple of years you are employed, you are 0% vested in employer contributions, then during (usually) the third year you become 100% vested.

A graded vesting schedule means that the vested interest in your employer’s contributions are increased incrementally each year. For example, you gain an extra 20% of vesting for each year of service until you hit 5 years at 100%.

History

Now that you understand the difference between cliff and graded vesting, here is a little background on 401k vesting rules and the two major reforms that affected vesting requirements for employers.

In 1986, Congress passed the Tax Reform Act, which, among other things, dictated the maximum vesting requirements that an employer could impose on its plan. At that time, Congress stated that an employer could not implement a cliff vesting schedule that lasted longer than 5 years, or a graded vesting schedule that lasted longer than 7 years (with vesting beginning at 20% in the third year).

In other words, if you worked for an employer who used a cliff vesting schedule, you would have to work there for 5 years before you’d get all the employer contributions. If you separated in year 4, you got nothing. If you worked for an employer who used the cliff vesting schedule, you would get an additional portion of employer contributions each year (starting no later than your third year) and be 100% vested by year 7. If, for example, you separated in year 5, you received only a portion of employer contributions.

The guidelines above are simply the most conservative an employer could be with their vesting schedules. Many employers were much more generous.

Fast forward to August 17, 2006, when President George W. Bush signed into law the Pension Protection Act (PPA). The PPA was another large reform geared toward retirement plans. The PPA made slight changes to the 401k vesting rules forcing employers to be more generous with their employer contributions.

Under PPA, employers were required to accelerate their cliff vesting schedules from 5 years to 3 years. And the graded schedules could go no longer than 6 years (up from 7 years previously).

PPA was a substantial piece of legislation that encompassed many aspects; vesting was only a small portion. Nonetheless, this turned out to be a big win for the 401k investors.

You can find more good information regarding 401k vesting rules through the IRS website.