In order to ensure we’re starting on the same page, let’s review what a 401(k) is. A 401(k) is a retirement savings plan sponsored by your employer. If you sign up to participate in a 401(k), you will tell your employer what percentage of your net income (income after taxes and other withholdings are taken out) you want invested in the retirement plan. This percentage will be taken out of each paycheck and invested in the plan. Taxes on the money invested aren’t due until you withdraw money from the account, ideally not until retirement.
Now, employers can sweeten the deal by offering a matching program, where they match the amount you invest up to a certain amount (usually between three and six percent, but it can be more). Vesting refers to the amount of ownership you have in the 401(k) funds your employer has contributed should you leave the company.
You are fully vested when you have ownership of 100 percent of funds contributed by your employer. You will always have access to the money you saved from your paychecks, regardless of how vested you are in your employer’s contributions.
Various vesting policies
There are two types of vesting policies that employers can use: graded vesting or cliff vesting.
Graded vesting increases the amount that you, the employee, are vested in the 401(k) each year you work at the company. These policies usually take from three to seven years in order for you to be fully vested. For example, a policy may increase the amount you’re vested in your 401(k) plan each year by 20 percent. So, in five years, you would be 100 percent vested (5 x 20% = 100%) in your 401(k) and could take those funds with you if you left the company.
Usually with graded policies, if you leave the company before the start of your second year, you will not have ownership in any of the company-contributed funds in your 401(k).
Cliff vesting takes a more “all at once” approach. Instead of giving you a percentage of vestment in the plan each year, vestment is withheld until you’ve been at the company for up to three years, at which point you will become 100 percent vested.
Regardless of the vesting policy a company uses, if you are laid off before you are fully vested in your retirement account, you will lose out on some or all of the money contributed by your employer. On the flip side, once you become 100 percent vested, all future employer contributions are 100 percent vested; the clock doesn’t start over again for new contributions.
How vesting affects your retirement savings plan
As a rule of thumb, you should contribute 10–15 percent of your net income to retirement savings, including any amount your employer matches. Always take full advantage of your 401(k) employer match, if you can, by contributing at least the same amount your employer matches. After all, that match is an immediate 50–100 percent return on your investment!
If you’re unsure you will stay at a job until you are fully vested in your 401(k), you could plan to contribute more to the plan in order to make up for losing out on all or part of your employer’s contributions when/if you leave.
Vesting policies are used by companies to encourage their employees to stick around. It’s not a bad strategy, and you can use it to your advantage when looking for a job. Familiarize yourself with your current employer’s vesting policy and compare it to any prospective new jobs. If you leave your current job—even for one with a higher salary—when you’re a year or less away from being fully vested in your current 401(k) plan, you’re missing out on a lot of cash for your future.
When looking at the benefits package of a new job, review their vesting policy as well. If you’re unsure it’s the right move for you and you see that they use cliff vesting, then you’ll miss out on any matching contributions if you leave the company before your three-year work anniversary.
If you want to learn more about your company’s 401(k) policies, talk to a human resources representative. You can also find this information on the 401(k) Summary Plan Description and on your annual benefits statement.
The more you know, the smarter you can be when it comes to saving for retirement and career planning!