When you’re just starting out saving for retirement and trying to understand what a 401k account is, there are a lot of challenging things you’ll find yourself being forced to understand such as investments, returns, and taxes. But then there is also the concept of a 401k vesting schedule.
Vesting is easily one of the most foreign sounding concepts you’ll encounter when you first start a 401k. Thankfully – it’s not anywhere nearly as complicated as you may think. All it requires is a simple understanding of what it is and how it will affect your fortune over time. Here’s the basics of what you need to know when it comes to vesting and your 401k account.
Your Money vs Your Employer’s Money:
It will help to think of your 401k as essentially made up of two important parts:
- The money you contributed.
- The money your employer contributed.
You ALWAYS get to keep all the money you contributed plus any gains that you earned from it. By law that is your money and it follows you no matter if you quit, change jobs, etc. However keep in mind that depending on the riskiness of your investing style your that balance could be lower or higher than what you’ve actually put into the account. It just depends on how the markets did.
The money your employer contributed to the plan is not necessarily all yours … at least not right away.
That’s where this concept of “vesting” comes in. When you vest in your 401k plan, it means you obtain the legal right to the money your employer gave you.
In other words if you leave the company and you’re only 20% vested, then you only get to keep 20% of what your employer contributed to your account. The remaining 80% goes back to the employer to do with as they please (generally to redistribute back to the other vested employees).
Usually the longer you’re with the company, the more you’re entitled to the employer contributions. Most employers will quantify this by telling up front when you sign up for their plan how many years of service you have to work until you are 100% vested in the account.
An Example of a 401k Vesting Schedule:
To illustrate the concept of 401k vesting, I’ll give you an example:
- When you start the plan, you’re 0% vested. Practically anything the company will give you during this first year is not legally yours yet.
- After 1 year you’re 20% vested.
- After 2 years you’re 40% vested.
- After 3 years you’re 60% vested.
- After 4 years you’re 80% vested.
- After 5 years you’re finally 100% vested. Now if you leave the company or switch jobs, you get to keep everything the company ever gave you (plus the gains).
Every employer’s vesting schedule is slightly different. Some of them are not necessarily linear like the one we just went through in this example. Check with your HR department for the exact details.
Why Do Companies Have Vesting?
The main reason for an employer to have a 401k vesting schedule is to provide an incentive for the long-term development and loyalty of its employees to the company. Many people will think twice about changing jobs if they know that they will be risking all the employee contributions they stand to receive.
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