Workplace retirement plans may have a vesting schedule. Here’s how it works.
Dear Dan,
I just started a new job and for the first time will have a 401(k) after a year. One of my co-workers told me to be careful about that because if I leave in less than five years I lose what’s in there. That can’t be true, right?
Worried Newbie
Dear Worried,
You’re right. But your friend may not be entirely wrong. The issue is a thing called “vesting.”
When you are vested, you have full ownership rights. By law, you are always 100% vested in your “elective deferrals.” These are the funds you contribute voluntarily from your wages. Whenever you terminate your employment, you will be able to take what you put in and any earnings on those contributions with you. Likewise, most “safe harbor” contributions made by an employer are always 100% vested.
However, for certain types of employer contributions, retirement plans like a 401(k) may add a vesting schedule. Vesting schedules are typically applied to employer matching and profit-sharing contributions and delay full vesting in those types of funds. If you leave the job before being fully vested, the unvested portion becomes a forfeiture.
When money is forfeited, the employer may use the funds to reduce employer contributions to remaining plan participants, pay plan expenses or divvy the forfeited amounts among the remaining participants in the plan. Typically, employers use forfeitures to pay plan expenses and reduce their outlay for their planned employer contributions.
Employee turnover can be costly to a business. By allowing vesting schedules on employer contributions, some potential costs are offset. This makes offering plans to employees less risky.
Two common vesting schedules are a three-year cliff and a six-year graded.
A three-year cliff means that none of the applicable employer contributions will be vested until the end of the third year of participation in the plan. At that point 100% of contributions become vested.
With a six-year graded vesting schedule, the percentage of the applicable employer contributions changes each year, starting at zero and rising to 100% by the end of year six. For example, there may be no vesting with less than two years of service, then 20% after year two starts, 40% after year three starts, 60% after year four starts, 80% after year five starts, then finally 100% vested from the start of year 6.
Your co-worker could be partially correct in that if your employer makes contributions to your plan, the plan has a vesting schedule and you leave before being fully vested, you won’t get all the funds in the 401(k). However, because the only funds subject to a vesting schedule are those made by an employer, I would not let vesting stop you from participating as soon as you are eligible. Remember, what you contribute is always fully vested immediately. You should at the very least contribute enough to get any company matching funds.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.
Originally published on MarketWatch. Read the original article here.