Learn about the concept of vesting and how to interpret the vesting schedule
What is Vesting?
“Vesting” refers to your ownership stake in the funds or other assets contributed by your employer to a retirement plan, stock options, or other benefit plans. Examples of assets that are subject to vesting include employer matching contributions or a share of the company’s profits that correspond to a certain percentage of the employee’s salary.
If you are 100% vested in the plan, the full balance of the plan account belongs to you, which means that your employer cannot take the assets from you for any reason. Conversely, if you are partially vested or not vested in the plan, you may have to forfeit some or all of the assets when the account balance is paid out—such as if you leave your job or do not work for more than 500 hours in a year for five years.
Basics of the Vesting Schedule
To encourage employee loyalty, employers often contribute to a retirement account or stock options plan based on a vesting schedule. These incentivizing programs created by the company determine when you will be fully vested in the employer’s contributions to the plan or acquire full ownership of them.
Through a vesting schedule, employers display their contributions to you as a carrot. The longer you work for the company, the more of the contributions you can keep. If you leave before you are fully vested in the plan, some or all of the money goes back to the company.
Vesting does not apply to any money you contribute yourself. (It is your money, and you can keep it even if you leave the company.) The more you contribute to your work retirement plan, the more you are 100% vested in your own contributions. Vesting schedules only apply to the money contributed by employers on your behalf.
Vesting Schedules for Retirement Accounts
There are three basic types of vesting schedules employees can use to gain full ownership of employer contributions to a retirement account or other benefit plan.
Immediate vesting schedules grant full ownership from the date of contribution. As the name suggests, employees with this type of vesting schedule are 100% vested in the employer’s contribution and have full ownership of it as soon as it arrives in their accounts.
Graded vesting schedules increase ownership over time. This vesting plan gives employees gradually increasing ownership of employer contributions as they complete a period of service, ultimately leading to them owning 100% of it. If an employee leaves before the end of that period, they retain only the portion of the employer’s matching contributions that they are vested in. Federal laws set a maximum of six years for graded vesting schedules in retirement plans.
Cliff vesting schedules provide benefits based on an all-or-nothing approach. These vesting schedules transfer 100% ownership to the employee in one lump sum after a specified period of service (for example, one year). However, until that service period is completed, employees have no ownership in the employer’s contributions and will have to forfeit all if they leave before that period is over. When they reach the full vesting date, they will own all of the employer’s contributions. Federal laws require that cliff vesting schedules in qualified retirement plans, such as a 401(k) or 403(b) plan, do not exceed three years.
Vesting Schedules for Stock Options
Under a stock options plan, an employer can provide stock options to employees, giving them the right to purchase company shares at a specified price regardless of the current market value of the stock. The expectation is that the market stock price will rise above the specified price before the option is exercised, providing the employee the opportunity to make a profit.
Vesting comes
Stock option plans typically come in either cliff vesting or graded vesting schedules. In a cliff vesting plan, employees gain access to all stock options at the same date. In a graded vesting plan, employees are allowed to exercise only a portion of their options at each time. Each option may carry a different vesting schedule.
For example, if employees are granted options on 100 shares with a cliff vesting schedule over five years, they must work for the company for an additional five years before they can exercise any of the options to purchase shares. In a graded vesting schedule over five years, they may be able to purchase 20 shares a year until they reach 100 shares in the fifth year.
Since most stock options are not part of the employee’s retirement plan, their vesting schedules are not subject to the same federal rules that govern matching contributions.
Example of Benefits of Different Vesting Schedules
Before taking a new job and leaving your current company, it’s essential to calculate how much you’ll be able to retain from your employer’s contributions to the vesting plan at your current company. These scenarios can serve as a reference when making employment decisions.
Tom’s employer provides a dollar-for-dollar matching contribution of $1 for every dollar of his $50,000 salary into his 401(k) account. To take full advantage of the match, he contributes a full 5% during his time at the company. He leaves the company after two years with an account balance of $10,000 ($5,000 in employee contributions and $5,000 in employer contributions).
In the case of an immediate vesting schedule, Tom would have complete ownership of any funds granted to him by his employer from the date of contribution. He would retain the full $5,000 in employer contributions (in addition to the money he contributed). This means he wouldn’t be worse off by leaving the company now compared to later.
Assuming Tom’s 401(k) plan is structured on a graded vesting schedule of five years that grants 20% ownership after the first year and then an additional 20% each year until he is fully vested (100%) after five years. After two years, Tom would be 40% vested. He would keep only $2,000 of the matching contribution worth $5,000 (0.4 multiplied by $5,000) and would forfeit the other $3,000. It might make sense for Tom to leave the company now, as he would have to stay three more years to become fully vested.
In the case of a cliff vesting schedule of three years, Tom would have no ownership of the employer contributions in the plan after two years. He would have to forfeit the full $5,000 that was granted to him during his employment. Tom might want to stay with the company for an additional year if retaining that $5,000 is important to him.
Final Thoughts on Vesting
Understanding the concept of vesting and the details of your company’s vesting schedule can help you plan for your financial future and reduce or eliminate the possibility of forfeiting any employer contributions when you leave the company. While you shouldn’t base your employment decisions solely on the company’s vesting schedule, calculating your benefits under different vesting schedules can help you time your departure correctly to retain the money and other assets your employer might grant you.
If you are unsure about your vesting schedule, contact your human resources department or check your benefits handbook to learn more about any vesting schedules that may apply to your retirement accounts or other benefits.
Questions
Frequently Asked Questions (FAQs)
What are shadow shares in the context of a vesting schedule?
Shadow shares are shares covered by a contractual agreement that have not yet been transferred. Once you sign a contract that initiates a vesting schedule, the shares covered by the agreement become “shadow shares” until they are fully vested and transferred to your ownership.
Why do some companies not use vesting schedules?
Companies use vesting schedules as a means to retain employees and provide competitive compensation, but they are not mandatory. Some companies may choose not to offer vesting schedules to prevent employees from losing equity stakes.
Source: https://www.thebalancemoney.com/what-is-a-vesting-schedule-and-how-does-it-work-4047274
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