Vesting: What It Is and How It Works in Retirement and Benefits

What Is Vesting?

A vesting schedule is an incentive program that gives employees benefits, such as stock options, after fulfilling a specified term of employment with the company. Vesting is a way for employers to retain top-performing employees.

Additionally, vesting schedules are used in inheritance law and real estate.

Key Takeaways

• When an employee is vested in employer-matching retirement funds or stock options, they have nonforfeitable rights to those assets.
• The amount an employee is vested often increases gradually over a period of years until they are 100% vested.
• A common vesting schedule is three to five years.

Understanding Vesting

In the context of retirement plan benefits, vesting gives employees rights to employer-provided assets over time, which incentivizes them to perform well and remain with the company. The vesting schedule determines when employees acquire full ownership of the asset.

Nonforfeitable rights accrue based on an employee’s length of employment. For example, in a 401(k) company match, matching dollars usually take years to vest, meaning the employee must stay with the company to receive them.

Within stock bonuses, vesting serves as a valuable employee-retention tool. For instance, an employee might receive 100 restricted stock units as an annual bonus. The stock vesting schedule could be as follows: 25 units in the second year, 25 units in the third year, 25 units in the fourth year, and 25 units in the fifth year. If the employee leaves after the third year, only 50 units would be vested.

Some benefits may vest immediately. Employees are always 100% vested in their salary-deferral contributions to retirement plans, SEP, and SIMPLE employer contributions. Vesting of employer contributions to a 401(k) plan may be immediate or occur after several years using either a cliff vesting schedule or a graded vesting schedule.

Traditional pension plans may have a five-year cliff vesting schedule or a three- to seven-year graded vesting schedule.

Full vesting in an employer’s contributions does not grant immediate access to the funds. Plan rules typically require reaching retirement age before penalty-free withdrawals.

Employees are always 100% vested in their own contributions to an employer-sponsored retirement plan.

Special Considerations

In wills and bequests, vesting often includes a waiting period to finalize bequests following the testator’s death. This waiting period reduces conflicts over the exact time of death and the potential for double-taxation if multiple heirs die after a disaster.

Startup companies often offer grants of common stock or access to employee stock option plans as part of compensation. These grants or options usually have a vesting period during which they cannot be sold to encourage loyalty and focus on the company’s success. A common vesting period is three to five years.