Retirement Planning Annapolis: Understanding Vesting
When it comes to retirement planning (in Annapolis, or anywhere, for that matter) “vesting” is an important term to understand.
What is Vesting?
Vesting refers to the length of time that you must be with an employer before any employer contributions to your retirement plan officially become yours. If you leave a job before vesting in the plan, you may not be able to take your full plan balance with you when you leave.
For example, let’s say you participate in a 401(k) program at work, to which both you and your employer contribute. You are always vested 100 percent in the money you contribute, because that money was yours to begin with and remains yours in the 401(k) plan. But what about your employer’s contributions? Although they are made to your 401(k) account, they may not be officially yours until you are fully vested. If you leave the company, you can only take the vested portion with you.
If you aren’t fully vested and leave your job, the unvested employer contributions will vanish from your 401(k) account.
Vesting applies to multiple types of retirement accounts, including 401(k)s and pension plans. Vesting can also be part of stock incentive programs.
For other considerations when changing jobs, read our recent blog post: Your Retirement Plan and a Job Change: What You Need to Know.
Types of Vesting
Organizations commonly use one of three basic types of vesting schedules when they set up retirement plans for their employees: Immediate, graded and cliff.
Immediate vesting is just what it sounds like: Any employer-contributed funds you receive are yours immediately. If you work for a company for just six months but receive a 100 percent matching employer contribution to your own 401(k) contribution, you have the right to all the money your employer has contributed when you leave, in addition to your own.
The government requires that employer contributions to certain types of retirement plans, such as SIMPLE IRAs and SEP-IRAs, always be immediately vested. That is not true of plans like 401(k)s and pensions, however.
Many people assume that their retirement plan goes with them whenever they leave and wherever they go. This can be a big oversight. Make sure you understand your company’s vesting schedule. Companies often use vesting schedules as an incentive to encourage employees to stay at the company. Immediate vesting is actually fairly uncommon.
In a graded vesting schedule, employees are granted the right to employer-contributed money over a gradual schedule.
For example, employees may be vested 20 percent per year for five years. Should you leave at the end of one year, you’d be entitled to 20 percent of an employer’s contributions, forfeiting 80 percent. But at the end of a five-year period, you’d be 100 percent vested in your employer’s contributions.
In a cliff vesting schedule, employees become vested at a specific date, such as after five years. They are not vested at all before then.
If your employer uses a cliff vesting schedule with a five-year schedule, you wouldn’t be entitled to any of the money your employer contributed until you had worked there for five years. After the five-year point, you become 100 percent vested.
Cliff vesting is common, especially in sectors with high turnover, as companies want to minimize benefits to employees who don’t stay long. With that said, leaving your employer six month before your five-year mark may not make the best financial sense.
What Vesting Can Mean to Your Retirement
In terms of planning your retirement savings, it’s wise to take advantage of an employer match if one is offered. This money is essentially “free” money. Just remember that in order to take advantage of that perk, there may be rules to follow.
Let’s say you make $75,000 and elect to save 5 percent for your retirement – you’d save $3,750. If your employer offers a 100 percent match, they also kick in $3,750, making your total savings $7,500. That’s a significant difference, especially as tax-deferred appreciation and reinvestment accrue over time. However, you’ll only really receive that money if you’re vested in the plan. If you’re vested immediately, great! But if you’re vested on a graded or cliff schedule, talk to a financial advisor about what leaving your company early means to your overall financial plan.
Note that your retirement money is still subject to general retirement plan rules regardless of your vesting schedule. You can’t withdraw retirement funds before the age of 59-½, for example, no matter what your vesting schedule is, without paying a 10 percent penalty to the Internal Revenue Service (IRS) and applicable taxes. So, immediate vesting doesn’t mean you get immediate access to the money without penalty!
What To Do If You Plan to Leave Your Job Before You Retire
What if you have either a graded or cliff vesting schedule and you plan to leave your job? Retirement may be a long way away, and a lot of people have several jobs before they retire.
Talk to a financial advisor about saving for retirement on your own. Although employer-sponsored plans like 401(k)s can be beneficial, because of employer-match opportunities, tax advantages and higher annual contribution limits compared to other plans, these benefits may not be fully yours in every circumstance.
Vesting can complicate your retirement planning. Lean on your financial advisor for help in making the right decisions to maximize your retirement funds.
Scarborough Capital Management has been helping busy people make smarter financial decisions for more than 30 years. With affordable 401(k) management services plus full-service financial planning and wealth management, our team of financial advisors helps clients with their retirement planning in Annapolis and nationwide. If you have questions about your retirement, schedule a no-obligation conversation with our team to see how we can help.