Since most of my plan sponsors implement a 401(k) program in order to recruit and retain higher-caliber talent, you should be comfortable with how vesting schedules work. Vesting schedules allow you to reward employee loyalty through the retirement plan. Let's take a look at how this works and the options available to you…
A vesting schedule is a type of service requirement that tells the participant when the company contributions they have received will mature. As a plan sponsor, you have the ability to select which vesting schedule you would like applied to the participants’ accounts. The first thing that you should know is that the employees’ contributions are always 100% vested so they are free to access their own contributions at any time in the form of participant loans, distributions, or rollovers. The next thing you should know is that the Safe Harbor 401(k) Plan requires that the Safe Harbor match or non-elective contributions are deemed immediately vested. Under this program, you cannot design the plan with a vesting schedule for these company contributions. However, the Traditional 401(k) Plan will allow you to apply a vesting schedule to company contributions so the retirement plan can help serve as a retention device. Let's learn more about the vesting schedules available to you.
The first vesting schedule is the most simple and has been referenced above. Immediate Vesting means that an employee is entitled to the company contributions as soon as they are contributed to the participant’s account. This is, therefore, the most generous of the vesting options. The second vesting schedule is known as the 3-Year Cliff. This schedule says that an employee who leaves the organization before their 3-year anniversary is not entitled to any of the employer contributions that have been made to their retirement account. However, once they have reached their 3-year anniversary, they are considered fully vested. The 3-year Cliff option is an all-or-nothing scenario when it comes to vesting. If you don’t feel like either of these schedules are right for your group of employees, you might consider the third option known as the 6-Year Graded schedule. This vesting schedule rewards the employees with a 20% maturity schedule for each year of service with the employer. For example, an employee who terminates from the organization in their first year of employment would receive 0% of the company contributions. If this same employee were to leave the company in their second year of employment, she would receive 20% of the company contributions, 40% of the contributions in her third year, and so on until being fully vested after six years of employment. The 6-Year Graded vesting schedule is the longest term you can set before an employee can become fully vested. The final option is the Custom Vesting Schedule which would allow you to design the term somewhere between the Immediate Vesting option and the 6-Year Graded program.
When speaking to plan sponsors about vesting schedules, I usually get two questions. First, “Is the vesting calculation based on the employee’s date of hire or their date of entry into the plan?”. The answer is the employee’s date of hire. Therefore, you could have a 3-Year Cliff vesting schedule with an employee who decides to enter the 401(k) after 3+ years of employment and they would be considered 100% vested upon the day they enter the plan. The second question I get is “What happens to the unvested company contributions when an employee leaves the organization?”. These unvested contributions are actually forfeited back to the plan. These assets are kept in a holding account within the 401(k) aptly named the forfeiture account. These assets are typically used to pay for plan expenses and/or to offset future company contributions.
As you can see, vesting schedules can help you target your bona fide employees, avoid funding your revolving-door employees, and reward employee loyalty to the organization. Join us for next week’s class when we discuss the benefits of an employee contributing to the 401(k) on a Pre-tax basis versus a Roth basis.