Companies use many strategies, such as offering company stock options or retirement plan contributions to employees on top of a base salary, to attract and retain top talent. The caveat is, you may not be able to keep this extra benefit immediately because of vesting rules that determine when an employee is entitled to receive stocks or the full amount of the contributions. Here’s how vesting works and why it’s an important consideration when comparing job offers and benefits.
What is vesting?
Vesting is a process that entitles employees to own any contributions made by their employer to their workplace savings plan, as well as stock or cash from an equity award, over time. The entitlement could be granted all at once, gradually over a length of service, or when a specific performance goal is reached. This could change if the employee separated from the company before meeting the vesting requirements.
Retirement plans often include vesting requirements for employer contributions, like 401(k) matches—extra money your employer adds to the account on your behalf—generally based on how much you put in.
How does vesting work?
It’s up to the employer to decide the vesting terms for employees. Usually, vesting is based on time. For example, a company might grant employees shares of company stock as part of their total benefits and then set a schedule for when each employee actually receives them. Whether it’s cash, shares of stock, or employer match to a retirement plan, generally, the longer you work for the company, the more benefits you get to keep until you’ve earned 100%.
Common types of vesting schedules
Here are some typical schedule types.
Graded vesting
That’s when you gain a little more ownership of what your employer is granting you over time. Let’s say your job uses a 5-year vesting schedule. In this case, you unlock 20% more of the benefit every year. So after 1 year, you’d be 20% vested, or own 20% of what your employer is giving you. After 2 years, you’d be 40% vested, and so on until 5 years, when you’d have unlocked all 100%.
Cliff vesting
This is when there’s a waiting period before the employee gains any ownership. In some cases, it might work like an all-or-nothing system. For example, with a 3-year cliff, you might get to keep 100% of the benefit as soon as you work for that employer for 3 years. But if you quit before 3 years, even by a day, you forfeit all the benefits subject to vesting.
Other employers might have a cliff, whereby the first portion of the benefit vests on a specific date, then the rest would vest over the following months, quarters, or years until reaching 100%. For example, if you have a 4-year vesting schedule with a 1-year cliff, you’d own 0% until you’ve worked there for a year, at which point you’d own 25%. After that, you’d vest gradually until year 4.
Performance vesting
Employers could base an employee’s ability to earn company stock on performance. Under this type of vesting agreement, employees become vested in shares they receive once the company or worker hits revenue, profit, or other targets.
Immediate vesting
Not all employers require employees to wait for their benefit to be vested. If your company uses immediate vesting, you get to keep everything they give you right away.
What does vesting mean in a 401(k)?
Vesting in a 401(k) applies only to employer contributions. It doesn’t apply to the money you put in. You will never lose your contributions—they are yours to keep, no matter how soon you leave the job.
Let’s say you contribute $40,000 to your 401(k) over the years, your employer chips in $1,000 in that time, and the plan uses an all-or-nothing 3-year cliff. If you quit before working 3 years, you keep the $40,000 you added to the plan but not a penny of the $1,000 in employer contributions. If you work more than 3 years and quit, you get to keep your $40,000 as well as all $1,000 of your employer’s contribution. This employer might also let you immediately keep 100% of their future contributions.
If instead the employer uses graded vesting on a 5-year schedule, grants equal portions of matching contributions with each passing year, and you leave after 3 years, you would be 60% vested in their matching contributions. That means you’d get to keep $600—because that’s 60% of their $1,000 contribution.
There are some circumstances that may speed up vesting. If your employer shuts down the retirement plan, you usually get to keep all employer contributions at that time. If you reach full retirement age, you also become 100% vested by then, regardless of how long you’ve worked at the employer.
How are vested contributions taxed in a 401(k)?
You don’t owe taxes immediately on employer contributions vesting in a traditional 401(k). You would only owe income tax on that money when you make withdrawals. The same is true for your own pre-tax contributions.
If you use a Roth 401(k) to make after-tax contributions, your employer could choose to add their contributions to a separate pre-tax account. You wouldn’t owe taxes on those contributions until you make withdrawals. However, since SECURE 2.0 legislation went into effect, your employer could instead choose to contribute to an after-tax account. In that case, you’d be taxed on their contributions each year; look out for a 1099-R tax form to report that income, even if you don’t withdraw it.
What does vesting mean for restricted stock units (RSUs) and other forms of company stock?
There are a few types of restricted awards, such as restricted stock units (RSUs), but generally they are grants with a value based on the company’s stock, which doesn’t give you shares in your company immediately. Instead, the employee must meet the vesting requirements before shares, or their cash equivalent, are distributed. At vesting, the payout counts as taxable income, even if it's shares. For example, if you meet the vesting requirement to unlock 1,000 shares at $20 a share, it counts as $20,000 of compensation at the time and you would be taxed on that $20,000.
Stock options and Stock Appreciation Rights (SARs) vesting
Stock options give you the right to buy shares of your employer’s stock at a set price, even if the market price is higher. So you effectively could buy stock at a discount. Stock Appreciation Rights (SARs) work in a similar way, letting you lock in any gains that may have been in the stock price. But the company may impose vesting rules before you can exercise. As in, you might not be able to exercise until a certain time.
You don’t owe income tax immediately after meeting the vesting requirements of stock options. If you choose to exercise your stock options though, you would owe taxes on the difference between the stock’s fair market value and the grant price. You would owe taxes again if you sell the shares for a profit.
What is a vested balance?
A vested balance is the amount of your benefits that is yours to keep. Your employer can’t take it back, even if you quit or lose your job. With graded vesting, the balance typically grows until you’ve earned 100% of the extra benefit because you’ve stayed with your employer.
Let’s say your 401(k) uses a 3-year graded schedule, allowing you to unlock around 33% a year. If you quit within 1 year, your vested balance is 0. If you quit after 1 year but before 2, your vested balance is about 33% of your employer’s contributions. After 2 years but before 3, the vested balance is about 67% of your employer’s contributions. It’s important to note that for stock options and stock appreciation rights, employees must still take action to retain them. The cash or shares will not fully become yours until you decide to exercise your award.
What does it mean to be fully vested?
To be fully vested means you’ve met the requirements to receive all your extra benefits. Typically, once you’re fully vested in a retirement plan, you also typically keep 100% of future employer contributions, but this depends on your plan.
Things to keep in mind about vesting
Vesting schedules are a factor to consider when you’re comparing jobs. If you get an offer from an employer that makes retirement plan contributions and/or grants equity, ask what the requirements are to become fully vested. A benefits package with longer vesting requirements may not be as generous as it seems at first glance. There’s no guarantee you’ll stay employed for the amount of time needed to earn the full package.
Can you negotiate for more favorable vesting terms? There tends to be a single set of vesting rules for the entire company with retirement plan contributions, leaving little wiggle room.
If you’re unsure how your vesting schedule or the taxes would work, consider speaking with a financial or tax professional.
