Quick Summary
Employee deferrals are always fully vested, but employer contributions can vest over time. Federal law limits defined contribution plans to a schedule no slower than three-year cliff or six-year graded vesting, and traditional safe harbor contributions must vest immediately. Forfeited amounts from departing employees must be used as the plan document directs, typically to pay plan expenses or reduce employer contributions. Plan terminations, including partial terminations, require full vesting for affected participants.
When you contribute to employees' 401(k) accounts through a match or profit sharing, that money does not have to belong to them immediately. A vesting schedule determines when employees earn the right to keep it.
Vesting is one of the plan design choices that affects cost, retention, and administration all at once, so it is worth understanding how it works.
What vesting means
Vesting is ownership. A participant who is 60% vested in employer contributions keeps 60% of that money if they leave, and the remaining 40% is forfeited.
Some money is always fully vested from day one:
- Employee salary deferrals, both pre-tax and Roth
- Rollover contributions from other plans
- Traditional safe harbor employer contributions
The allowed schedules
For matching and profit sharing contributions in a defined contribution plan, federal law sets the slowest schedules a plan can use:
| Years of service | 3-year cliff | 6-year graded |
|---|---|---|
| 1 | 0% | 0% |
| 2 | 0% | 20% |
| 3 | 100% | 40% |
| 4 | 100% | 60% |
| 5 | 100% | 80% |
| 6 | 100% | 100% |
A plan can always use a faster schedule, including immediate vesting.
Exceptions and required full vesting
Safe harbor contributions. Traditional safe harbor contributions must vest immediately. Safe harbor contributions under a qualified automatic contribution arrangement (QACA) can be subject to a cliff schedule of up to two years.
Events that require full vesting. Participants must become fully vested when they reach the plan's normal retirement age and when the plan terminates. A partial plan termination also requires full vesting for affected participants. A partial termination is generally presumed when more than 20% of plan participants lose their jobs through employer action in a plan year, such as a layoff or restructuring.
Many plans also choose to fully vest participants at death or disability.
How service is counted
Most plans count a year of vesting service as any 12-month period in which an employee works at least 1,000 hours. Plans can use a lower threshold, or use the elapsed time method, which counts the length of employment rather than hours.
Plans may exclude certain service, such as service before age 18. Under the SECURE Act and SECURE 2.0, long-term part-time employees who become eligible to defer receive vesting credit for each year in which they work at least 500 hours.
Rehired employees and breaks in service follow their own rules, which can get complicated. Your third-party administrator should track service consistently with the plan document.
Forfeitures
When an employee leaves before becoming fully vested, the unvested portion is forfeited. Forfeitures typically occur when the former employee takes a distribution or after a period of breaks in service.
The plan document dictates how forfeitures are used. Common options include paying plan expenses, reducing future employer contributions, and reallocating to remaining participants. Proposed IRS regulations would require forfeitures to be used no later than 12 months after the end of the plan year in which they occur.
In recent years, some lawsuits have challenged sponsors' use of forfeitures to reduce employer contributions rather than pay plan expenses. Many of those claims have been dismissed, but the trend is a reminder to follow the plan document exactly and document how forfeitures are used each year.
Choosing a schedule
The right schedule depends on your goals:
- Retention. A longer schedule rewards employees who stay.
- Recruiting. Immediate vesting can be a selling point, especially in competitive hiring markets.
- Cost. In high-turnover workforces, vesting can meaningfully reduce the cost of employer contributions.
- Simplicity. Immediate vesting eliminates forfeiture tracking and many service-counting questions.
- Plan design. If you adopt a traditional safe harbor design, those contributions vest immediately regardless.
Changing the schedule
A plan can be amended to change its vesting schedule, but an amendment cannot reduce the vested percentage participants have already earned. If a new schedule is less favorable, participants with at least three years of service must be allowed to choose to remain under the old schedule.
Want a second look at whether your vesting schedule still fits your workforce? Brian Williams, CPFA®, of Northshire Consulting LLC | Registered Investment Advisory Firm meets with business owners to review plan design. Call 203-401-6062, email bwilliams@northshireconsulting.com, or visit northshireconsulting.com to schedule a plan review.
Frequently asked questions
Do vesting rules apply to employee contributions?
No. Employees are always fully vested in their own salary deferrals.
What happens to unvested money when someone leaves?
It is forfeited and used as the plan document directs, such as paying plan expenses or reducing future employer contributions.
Can we make our vesting schedule faster?
Yes. A plan can be amended to provide faster vesting at any time.
This material is for educational purposes only and is not individualized investment, tax, or legal advice. Advisory services are offered through Northshire Consulting LLC | Registered Investment Advisory Firm.