Vesting refers to the type of ownership your employer plan has in the money you contribute.
401(k) plans are “vested”, which means that employer contributions belong to the employee immediately, while the employee’s own contributions generally belong to the employee only after a vesting period.
Many companies’ policies require employees to be fully vested immediately. Other employers have a graded vesting schedule, in which the money you contribute is subject to different degrees of vesting based on tenure with the company.
Why Do Employers Use Vesting?
The main reason 401(k) plans use vesting is to provide an incentive for employees to stay with the company for a specific amount of time.
Employers want employees who remain with the company long term, and vesting is a way to reward those who do.
Another reason 401(k) plans use vesting is to encourage contributions.
For example, if employees know they can keep 100% of employer match dollars after four years with the company, it might help motivate them to contribute more than 3% or 5%.
Keep in mind that retirement plans are designed to help employees save for retirement, so if employers did not have some kind of an ownership structure, employees might be tempted to take 401(k) money out for other uses.
How 401(k) Vesting Works
Typically 401(k) plans work like this:
You start with a 401(k) plan, where your contributions are not vested. In other words, you don’t necessarily own them; they belong to the employer until you leave employment or become fully vested.
After two years (or whatever is specified by the plan), you reach “proportionate” vesting. This means that you own a portion of your contributions, while the employer remains an owner until you reach 100% vesting.
After four more years (or whatever is specified in the plan), employees become fully vested in their 401(k) contributions.
How Do I Know if I Am Fully Vested in My 401(k)?
Your plan administrator will be able to tell you how much of your contributions are vested and how much you have to work before you can access those funds.
Vesting schedule outlines when you obtain ownership of 401(k) contributions.
Many plans also provide information about your total account balance, including employer contributions and employee contributions that are vested or partially vested.
You should receive this information every year in the plan’s annual statement, which you can access online or by paper if requested.
Immediate vesting is the simplest form of 401(k) vesting that a plan can offer.
This occurs when all employer contributions become 100% vested as soon as they are made available to the employee.
If you quit before you have been with the company for a full year, you would still own all the 401(k) dollars you contributed.
This vesting schedule allows you to own contributions in different percentages depending on how long you have been with the company.
For example, contributions might be 20% vested after one year, an additional 30% after two years and the final 50% after three years.
In this vesting schedule, you are entitled to basically none of your match or profit-sharing dollars until you work more than a certain number of years with the company.
For example, if you have to work five years before vesting or employer contributions become available, 401(k) dollars are essentially locked up for the first year.
How to Find Your 401(k) Vesting Schedule
You can typically find vesting schedules in the Summary Plan Description (SPD), which is a document that 401(k) plans are required to make available to plan participants.
The SPD will outline all of the plan’s rules, including vesting. You can request a copy from your plan administrator or download it from the company website.
You will see “vesting schedule” in the left side toolbar when searching for your 401(k).
What Happens If I Leave Before I Am Fully Vested in My 401(k)?
If you leave your 401(k) plan before becoming fully vested, the employee contributions become available to you immediately.
You will start receiving employer contributions when they are vested or following a schedule that is outlined in your plan document.
How Does Vesting Affect How Much I Should Contribute to Retirement?
Vesting means that each time an employee stays with an employer for a year, he or she is allowed to keep a portion of contributions.
The number of years the employee stays with an employer affects how much he or she can keep from contributions, and this is expressed as a percentage known as one’s “vesting percentage.”
If your 401(k) plan is generous enough, you might decide to contribute as much as you can afford even if it’s not fully vested.
That way, once you hit the vesting amount, you will have a nice nest egg for retirement.
Your 401(k) plan should offer some form of the vesting schedule.
It’s important to know what the rules are so you can make an informed decision about how much to contribute to your 401(k).
Once you understand your contribution schedule, it might be easier for you to start saving for retirement as early as possible.
401(k) Plan | A Complete Beginner's Guide
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k).
Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978.
With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn.
Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006.
Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free.
Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings.
Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer.
Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion.
If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade.
If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion.
To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn.
With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them.
Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire.
If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term.
You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket.
On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true.
In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up.
Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change.
A smart move may be to hedge your bets and divide your contributions between the two types of IRAs.
If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each.
In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other.
When you do decide which avenue to take, make sure to thoroughly evaluate your decision.
Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible.
Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky.
You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
Pension vs 401(k)
If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement.
There is typically no option to grow this amount, but it also does not require any financial investment from the employee.
Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer.
401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.
How Much Should I Contribute to My 401(k)?
Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k).
There are limits on how much you can contribute to it that are outlined in detail below.
There are two methods of contributing funds to your 401(k).
The main way of adding new funds to your account is to contribute a portion of your own income directly.
This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)).
The system mandates that the majority of direct financial contributions will come from your own pocket.
It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return.
The second method comes from deposits that an employer matches.
Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee.
However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan.
This is especially important to keep in mind if you want to utilize both types of plans.
A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year.
For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000.
If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions.
The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.
Plan in Advance
401(k) Plan FAQs
Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.