Retirement Plan Vesting and Vesting Schedules Explained
By Luke Swanson, QKA, CIP
What is vesting as it relates to a defined contribution retirement plan?
“Vesting” is the process by which certain employer contributions to a defined contribution retirement plan become nonforfeitable to plan participants. When distributions are taken from the plan, plan administrators can determine how many years of vesting service a participant has and, therefore, what percentage of certain employer contributions are truly owed to a participant and what percentage could be forfeited back to the plan.
How is vesting applied in defined contribution retirement plans?
Certain money types must be 100 percent vested. This includes employee contributions (pretax deferrals, Roth deferrals, and nondeductible after-tax contributions), rollover contributions, actual deferral percentage (ADP) safe harbor contributions, qualified nonelective and qualified matching contributions, and SIMPLE 401(k) contributions.
Money types that may be subject to a vesting schedule include nonsafe harbor matching contributions, profit sharing contributions, actual contribution percentage (ACP) safe harbor contributions, qualified automatic contribution arrangement (QACA) ADP safe harbor contributions, and QACA ACP safe harbor contributions.
Certain events require a participant to be 100 percent vested. First, nonsafe harbor matching and profit sharing contributions must be 100 percent vested if an employer requires two years of service prior to an employee becoming eligible for those contribution types under the plan. Upon partial plan termination—which can occur when a significant number of employee layoffs or terminations occurs—the affected participants must be 100 percent vested. Under full plan termination, all participants must be 100 percent vested. If there’s a complete discontinuance of contributions to the plan—which is based on facts and circumstances—or if the plan amends to become a frozen plan, all participants must be 100 percent vested. Finally, when participants attain normal retirement age as defined in the plan document, they must become 100 percent vested.
A participant may also become 100 percent vested because of plan design. If allowed in the plan document, participants may become 100 percent vested due to such events as death, disability, or attainment of early retirement age.
What are the possible vesting schedules?
Three types of vesting schedules are permitted in defined contribution retirement plans.
Graded Vesting
Under this vesting schedule, an employee’s vesting percentage gradually increases on an annual basis as she accrues each additional year of vesting service. A six-year graded vesting schedule is the least generous, or maximum, schedule length allowed under a graded vesting schedule. That means that at one year of vesting service, an employee is zero percent vested, then must gain 20 percent vesting with each additional year of vesting service he obtains: two years = 20%; three years = 40%; four years = 60%, five years = 80%, and six years = 100%.
An employer may choose to follow a more favorable graded vesting schedule, such as a four-year graded vesting schedule of 25 percent increases each year until 100 percent vested at year four. The six-year numbers previously mentioned are the minimum that an employee must be credited with for those years of service. For example, an employer may not use a graded vesting schedule where an employee is only 40 percent vested in year four; the employee must be at least 60 percent vested in year four. Alternative vesting schedules need not have identical increases for each year of vesting service accrued but must meet the minimums just described.
Cliff Vesting
Under this approach, an employee remains zero percent vested until he obtains a plan-defined number of years of vesting service, at which point he will become 100 percent vested. A three-year cliff vesting schedule is the least generous, or maximum, schedule length allowed under a cliff vesting schedule. It means that an employee must be 100 percent vested after attaining three years of vesting service. An employer may choose a more favorable cliff vesting schedule, such as a two-year cliff.
NOTE: QACA ADP safe harbor contributions may be made subject to vesting, but a two-year cliff vesting schedule is the maximum schedule length allowed for these contributions.
Immediate Vesting
As the words imply, immediate vesting means an employee is 100 percent vested in employer contributions as soon as they are contributed and they may never be forfeited. Immediate vesting not only applies to certain money types discussed earlier, but, by plan design, an employer may choose to make its contributions immediately vested, even though it could have applied a graded or cliff vesting schedule to employer contributions made to plan participants.
