Optimizing your 401k is an important step in building your retirement nest egg.
Of course, there are many items to check off your list when it comes to understanding your 401k, including the contribution amount, deadlines, withdrawal guidelines, and matching programs to name a few. You may have also heard you should contribute as much as possible to your 401k, or at least enough to get matching funds from your employer.
There is also another important factor to understand: 401k vesting. If you’re participating in a company-sponsored 401k, you may be wondering what it means to be “vested” in your plan. Let’s take a look at a few considerations:
- What the vesting definition is
- Why companies incorporate vesting policies
- Key points to keep in mind as you manage your 401k
What Does 401k Vesting Mean?
When your employer makes matching contributions to your 401k, they will often delay the transfer of ownership to you. Any funds you contribute yourself belong to you right away, but the company match amounts are typically transferred to you gradually over one or more years. This transfer of ownership is what is meant by the term vesting.
Once an employer match has fully vested, you have total ownership of those funds. You own them outright and they are yours to keep if you decide to leave your employer, are laid off, or even get fired.
When Can I Withdraw from a 401k?
Having a fully vested 401k does not necessarily mean you are completely free to withdraw funds. With traditional 401k plans, you have to be at least 59½ years old before you can make withdrawals without incurring a tax. Withdrawing early can result in a 10% penalty in addition to any taxes from ordinary income.
Why Do Companies Implement 401k Vesting Guidelines?
One reason companies use vesting is to encourage employee retention. If you know a certain amount of money is going to become yours simply by waiting, you’re less likely to leave the company. It’s essentially “free” money that becomes yours depending on your years of service.
Take Ashley as an example. Ashley has been with her current employer for several years, and is just six months away from becoming fully vested in last year’s company match. She has been considering a transition to a new company, but depending on the salary increase, it may make sense to continue working in order to gain ownership of the previous year’s contribution.
What are 401k Vesting Schedules?
Some employers offer immediate vesting, which means company contributions to your 401k are immediately yours.
However, other companies often follow one of two primary vesting schedules:
Cliff Vesting Schedule
Company contributions transfer to the employee after a set number of years of employment. For example, suppose the guidelines specify a cliff of three years. The employee would own 0% at the end of year one, 0% at the end of year two, and 100% at the end of year three.
Graded Vesting Schedule
Employees become vested in increments over a certain number of years at the company. For example, the employee may own 20% after two years, 40% after three years, 60% after four years, 80% after five years, and 100% after six years.
| Years of Service | Cliff Vesting | Graded Vesting |
|---|---|---|
| 1 | 0% | 0% |
| 2 | 0% | 20% |
| 3 | 100% | 40% |
| 4 | 100% | 60% |
| 5 | 100% | 80% |
| 6 | 100% | 100% |
Source: IRS
Tip: Know Your Vesting Policy and Guidelines
Become familiar with your company’s vesting policy and ask your HR department or benefits administrator about the vesting guidelines and vesting periods. This makes a big difference if you’re considering leaving a company. For example, if your employer uses a cliff schedule, and you are considering leaving shortly before you become fully vested in an employer contribution, it may be worth delaying the decision to leave your job.
Other Key Considerations
Maxing out your 401k contributions, or at the very least contributing the minimum amount to take advantage of company contributions, is almost always a good move.
If your 401k has a limited selection of funds or high fees, you can consider contributing the minimum amount to get the company contributions, and then investing other funds into an IRA or Roth IRA. (There are income limitations with these options, so check with a tax professional before opening a new individual retirement account.)
Familiarize yourself with your company’s vesting guidelines and schedules, and consider your HR colleagues as informational resources.
Steps to Better Understand Your 401k
- Discuss your 401k options with one of our fiduciary financial advisors. As a client, you receive a complimentary analysis of your employer plan. Personal Capital can also actively manage your 401k.
- Sign up for Personal Capital’s free financial tools to use the Fee Analyzer, where you can analyze the fees you are paying on your 401k. You can also run the Retirement Planner to see your chances for a successful retirement and the Investment Checkup to visualize your portfolio.
Get Started with Personal Capital’s Free Financial Tools