What Is A Vesting Schedule And How Does It Work?

Vesting schedule

Companies often offer generous perks to attract and keep good workers. Depending on the type of benefit, an employer might implement a vesting schedule, requiring people to stay with the company for a while before receiving certain benefits. Vesting schedules are often used for contributions to a company 401(k) plan and employee stock programs. Companies use vesting as a way to reward employees for their loyalty and hard work.

What is vesting?

Vesting is the process of earning a benefit that an employer offers over time. Employers often offer generous benefits and perks to employees in the form of 401(k) contributions or stock options. But some companies require someone there for a certain amount of time before taking ownership of that benefit — this is known as vesting.

Once an employee is vested, the asset the company offers, whether it be company stock or money in a worker’s retirement account, officially belongs to the employee. The company can’t take back these assets once they’ve changed ownership.

The vesting schedule is the timeline during which an employee becomes vesting in a particular benefit. Some companies have gradual vesting schedules, where an employee slowly earns a benefit over time. Others require that a company work there for a certain number of years, after which point they become fully vested all at once.

Types of vesting schedules

Different companies handle their vesting schedules differently. There are generally three different forms that a vesting schedule can take.

Immediate vesting

Immediate vesting is when an employee has access to a particular benefit as soon as they start at the company. There’s no waiting period. Roughly half of employers use immediate vesting for retirement accounts, according to a Vanguard survey.

Graded vesting

Graded vesting is when an employee gradually receives a certain benefit over time. For example, a company might offer an employee 25% of a benefit in their first year of service, 50% in their second year, and so on. The Internal Revenue Code requires that graded vesting schedules be no longer than six years.

Cliff vesting

Cliff vesting is when a company requires an employee to work for a certain number of years before receiving any of a specific benefit, but then they receive the full benefit amount at once.

Vesting and retirement accounts

The most common situation where an employee might encounter a vesting schedule is in the case of retirement contributions. Companies often offer to match a worker’s 401(k) contributions up to a particular percentage of their income. The average employer match is 4.3%.

Some companies have immediate vesting, meaning employees receive an employer contribution as soon as they start at the company. But others may require employees to work there for a certain number of years.

Retirement vesting schedule example

Imagine that a company offered employees an annual 6% match, but on a graded vesting schedule. In the first year someone works at the company, they don’t receive any of their employee match. The second year, they receive a 2% employee match. In the third year, they receive a 4% match. And finally, an employee receives their full 6% match in the fourth year of employment and each year after that.

Once the employer contributions are in a worker’s retirement account, that money belongs entirely to the employee. They can take it with them when they leave, and under IRS regulations, the company can’t revoke it for any reason.

Vesting and stock options

Another example of when a company might use a vesting schedule is in the case of an employee stock program. Some companies may offer certain employees shares of stock as a form of compensation. In other cases, they might allow employees to purchase company stock at a fixed price, which may be lower than its market value.

Stock options vesting schedule example

Suppose a company offers stock options, where employees can purchase up to 100 shares of stock at a discounted price. The company uses a cliff vesting schedule of five years. For the first five years, the employee works at the company, they can’t buy any shares through the stock options program. But once they reach five years with the company, they can purchase all 100 shares at once.

The bottom line

Companies often use vesting schedules to encourage employees to stay with the company. If someone knows they’ll be receiving a generous benefit if they remain with the company for a certain number of years, they might be more likely to do so. Make sure you understand your company’s vesting schedule to take full advantage of your benefits.

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