Employer matching, vesting, and your 401(k): what you need to know
Ah, the bliss of having a 401(k) match. Your employer contributes money to your account, matching what you save from your own paycheck pre-tax, usually matching between 50% and 100% of the amount the employee contributes themselves.
Matching is a terrific benefit, and approximately 92% of companies that offer 401(k) plans provide a match. To make the most of your employer match, you need to understand when the funds legally become yours, through vesting.
Here's an example of how powerful an employer match can be: If your salary is $60,000, and you contribute 5%, you'd save $3,000 per year for retirement. But then, if your company offers a 50% match, they'll kick in a total of $1,500 on top of your contribution, so your account actually receives an annual contribution of $4,500 -- a nice sum that will compound over time to help serve you in retirement.
What Are Vesting Schedules and Why Do They Matter?
But not so fast: Most 401(k) participants need to vest before matching money actually becomes theirs to keep. While you always own the money you contribute from your own paycheck, you don't necessarily own the employer's matching contribution right away.
The vesting schedule for your particular plan should be clearly spelled out in the information your employer provides about its 401(k) plan. If you don't see it, ask someone in your human resources department or the employee who provided you with new hire forms.
The process of becoming vested takes place on a vesting schedule. If you are indeed vested, then you own the rights to the money contributed by the company in your retirement account. If you leave the company's employment before you are vested, you don't own the company contributions. You have to forfeit the matching 401(k) money if you leave the employer.
You need to know your company's vesting schedule to make smart decisions about your 401(k) funds and your career trajectory.
Consider this: You have $12,000 in your 401(k) account, but you're not currently vested in $6,000 of it. You get an exciting new job offer that will boost your salary significantly. If you're going to be fully vested in three months, it may make sense to wait until you vest before giving notice. But if you're not going to fully vest in the $6,000 for two years, it may be more prudent to take the higher salary right away. You'll forfeit $6,000, but if your salary adjustment results in more than $6,000 over two years, you win.
It's a good idea to calculate the difference when you're weighing whether to accept a higher-paying job, and leave unvested 401(k) funds on the table.
There are three major types of vesting schedules.
1. Immediate: You own the employer matching dollars as soon as they are contributed. If it's in your 401(k) account, it's yours.
2. Graded: In a graded vesting schedule, you vest in a certain percentage of the employer contribution in a set period of time, until you are fully (100%) vested.
Under a graded vesting schedule, employers must vest their employees at least 20% at the end of two years, and by another 20% annually in subsequent years. The longest a graded vesting schedule can last, in other words, is six years, at the end of which you'd be 100% vested.
For example, if your employer has a six-year graded vesting schedule, and you leave after three years, you will own 40% of the amount the employer has contributed, if they vested 20% at the end of two years and 20% at the end of the third year.
Let's say you were contributing 5% of a $60,000 salary. You'd have $9,000 at the end of those three years from your own contribution, money you're immediately vested in. If your employer matched 50% of your contribution, you'd have $4,500 in matching funds as well. But you'd only be vested in 40% at three years, so you'd only own $1,800. You'd forfeit the remaining 60%, or $2,700, when you leave.
3. Cliff: In a cliff vesting schedule, you fully vest at a specific time, and there is no interim percentage vesting like with a graded vesting schedule. Employers have up to three years to vest employees in a cliff vesting schedule.
Assume you leave an employer with a three-year cliff vesting schedule after two years. You've contributed 5% of your $60,000 salary, or $6,000, over two years. With a 50% employer match, you received $3,000 in employer contributions. But under a cliff vesting schedule, you won't be vested in any of the employer's contribution until you've been working there for three years, so you will forfeit all of the matching money from your employer if you leave after two years.
If graded and cliff vesting schedules make 401(k) matches look less attractive, think about your employer's motivations for designing benefits this way. The company's aim is to incentivize employees to stay working there. Graded and cliff vesting schedules are tools for management to use in increasing employee retention. Further, it's a positive sign if your employer is prudently allocating funds. Matching money vested in the 401(k) account of a six-month employee who quits a month later isn't the optimal use of cash.
Benefits of a 401(k) Plan
Whatever the vesting schedule of your 401(k) plan, it doesn't impact the many other financial benefits from participating in one.
First, you can save a lot of money for retirement. For 2019, you can contribute as much as $19,000 to a 401(k) plan ($25,000 if you're 50 or older) per year.
Second, your contributions to a 401(k) plan are tax advantaged. Contributions are taken out of your paycheck pre-tax, and the money grows tax-free until you withdraw the funds in retirement. (Vested matching contributions grow tax-free, too.) Since the money is taken out pre-tax, you don't pay taxes on it the year you contribute it. The pre-tax contributions will lower your taxable income for the year, which could even push you into a lower tax bracket.
Third, your 401(k) savings are automatic. Once you set up your desired contribution amount, the money simply disappears from the amount in your paycheck, and goes straight into your 401(k). Automatic savings mean that you'll never miss a contribution. Plus, you're relatively free of temptation to spend it on something besides retirement savings.
Lastly, you'll likely be able to choose from multiple investment options your company provides in its 401(k) plan. The average U.S. 401(k) plan lets participants choose from about 13 stock funds (10 U.S. funds and three international funds), plus bond funds, and other fixed-income funds.
What to Do With a 401(k) Plan if You Leave a Company
Whether you're vested or not, make specific plans for your 401(k) if you leave a company. It's rarely a good idea to cash it out. You'll be assessed penalties and taxes, unless you're age 59 1/2 or older, and you miss out on the chance for the money to grow over time, negatively affect your retirement savings.
You may be entitled to keep your account in a given 401(k) plan if you leave a company, provided you have a certain level of savings in it. If you have a good range of choices and your new company doesn't offer a 401(k), this can be a smart move. The fewer places you have retirement accounts, the easier they are to keep track of.
If your new company has a 401(k), most will let you roll over 401(k) funds. If you leave a company and don't want to leave your funds there, or don't have a sufficient amount for that to be an option, it's a good idea to do this. You have 60 days to complete the rollover, and after that deadline passes, you'll be assessed penalties and fees for a withdrawal.
If your company doesn't have a plan, you can roll over 401(k) funds to an Individual Retirement Account (IRA).
Whatever you choose, be sure to keep the paperwork for your retirement accounts and update the company, the plan administrator, and any financial institution that has your accounts if your contact information changes; you want them to be able to send you statements and any other relevant information, whether you're 22 or 62. You also don't want to forget that you have the money, which is possible if you change jobs frequently.