Choosing Vesting Requirements for Qualified Retirement Plan Purposes

By Kristoffer Aas, QKA®, EdM

While vesting standards have long existed to retain and reward employees, a financial literacy gap can prevent participants from maximizing their vesting opportunities and employers from reusing the nonvested (or forfeited) contributions when an employee terminates employment. The literacy gap can have an even bigger effect on employees who frequently move from one job to the next. This article will attempt to fill this gap by answering some of the most important vesting-related questions.

What is Vesting?

Vesting is the process by which employer contributions become nonforfeitable to participants by earning years of vesting service. When a participant terminates employment and requests a full distribution, the vested percentage determines how much of the employer contributions can be distributed and how much (if any) is forfeited back to the employer.

Some contributions are immediately vested (e.g., elective deferrals, rollovers, after-tax employee contributions) and some are subject to a vesting schedule (i.e., profit-sharing contributions or employer match). Safe harbor contributions can fall into either category depending on the type and purpose.

What are the Permitted Vesting Schedules?

How long must an employee serve his employer before becoming fully entitled to employer contributions made on his behalf?  The maximum permitted vesting schedule for a defined contribution plan is either a six-year graded or a three-year cliff schedule. The six-year graded schedule gradually increases 20 percent for every year of service from year two to year six while the three-year cliff schedule increases from zero percent to 100 percent after three years of service. While an employer may choose a more favorable schedule, it must at least satisfy these minimum vested percentages at those specific years of service. For example, if an employer elects a four-year graded schedule, year two must be at least 20 percent and year three must be at least 40 percent. While an employer may not combine a graded and a cliff schedule under the same contribution type, it can generally choose a different type of schedule for each contribution type (i.e., a graded schedule for matching contributions and a cliff schedule for profit-sharing contributions).

How is Service Toward Full Vesting Measured?

The same service crediting methods that apply for determining whether a participant has met a plan’s eligibility conditions, also apply in determining the extent to which  vesting requirements have been met.  These are the actual hours method, the equivalency hours method, and the elapsed time method. There is a significant difference, however.  For eligibility purposes, if an employer elects either the actual hours or the equivalency hours method, the participant must wait until the end of the 12-month computation or measuring period to earn a year of service.  However, when determining service for vesting purposes, the participant will earn a year of service immediately upon satisfying the hourly requirement (no more than 1,000 hours can be required). In other words, she does not have to wait until the end of the 12-month period.

Note that the computation or measuring period must be a 12-consecutive month period: most commonly, the plan year, calendar year, or anniversary year.

The elapsed time method does not count hours, but, rather, the total number of 12-month periods that the employee has worked during his period of service. For example, an employer requires 1,000 hours of service in a 12-consecutive month computation period when determining both eligibility and vesting requirements. The same difference between eligibility and vesting described above applies here, too.    For eligibility, the participant must wait until the end of the 12-month period to be credited the year of service—regardless of what date the 1,000 hours was completed. For vesting, however, the participant is credited with a year of service on the date that she completed the 1,000 hour requirement. She does not have to wait until the end of the 12-month period.

NOTE: Beginning with 2021 plan years, long-term, part-time (LTPT) employees and former LTPT employees (those who first entered as LTPT employees and then satisfied standard eligibility) earn one year of vesting service when credited with 500 hours during a 12-month vesting computation period.

What happens to nonvested employer contributions that are refunded to the plan?

When a participant terminates employment and takes a full distribution of all vested sources or experiences five consecutive breaks-in-service, the nonvested employer contributions are refunded to the plan. The contributions can then be used for paying administrative plan expenses, restoring a rehired participant’s account balance (only possible before incurring five consecutive breaks-in-service), reducing future employer contributions, or reallocating the contributions to other participants.

Generally, the employer will have previously elected how each forfeited employer contribution will be spent (e.g., forfeited matching contributions must be used for reducing employer contributions). The forfeitures must ideally be used as soon as possible, but no later than 12 months following the end of the plan year in which the benefit was forfeited, or else be deemed an operational failure correctable under the Internal Revenue Service’s Employee Plans Compliance Resolution System.

Are there any exceptions that require 100 percent vesting?

While different types of contributions are subject to different vesting schedules, the following situations create an immediate 100 percent vesting requirement.

  • Attaining normal retirement age (whether defined by the plan, or if earlier, the Internal Revenue Code)

  • Partial or full plan termination (partial termination often occurs if an event causes 20 percent or more of the participants to be terminated or lose a benefit)

  • Frozen or discontinued contributions (where the former is an amendment, and the latter is based on facts-and-circumstances)

Other plan-defined situations could require immediate 100 percent vesting, such as reaching early retirement age, death, or incurring a disability (as defined by the plan).

A two-year eligibility service requirement for nonsafe harbor matching contributions or profit-sharing contributions also results in immediate 100 percent vesting of that contribution type. And, lastly, if a participant dies while performing qualified military service, the survivors may be entitled to the same vesting benefits that would have been offered to them had the participant first returned to employment and then passed away. Employers may also provide this option to beneficiaries of participants who incur a disability.