Saving for retirement is an important part of planning for your financial future. Many employers offer special retirement accounts called 401(k)s that employees can use to receive a tax incentive for saving for retirement. Many employers also make contributions on top of the money employees put into the account.
While an employer making contributions to employee retirement accounts is a common and valuable perk, the money your employer puts in your 401(k) might not be your property right away. A system called 401(k) vesting determines when an employer contribution to your 401(k) officially becomes yours.
What Is a 401(k)?
A 401(k) is a type of tax-advantaged retirement account employers can offer as an employee benefit. They are tax-advantaged in that the state and federal governments give taxpayers perks for making contributions to their 401(k). There are two types of 401(k), each offering different tax benefits.
The most common type of 401(k) is the traditional 401(k). When you contribute money to a traditional 401(k), you can deduct the amount of your contribution from your income when you file your tax return. That can reduce your tax bill for the year.
The less common type of 401(k) is the Roth 401(k). Like with a Roth IRA, you pay taxes as normal when you contribute to a Roth 401(k) account. However, when you make withdrawals from the account, you pay no taxes on them. Contributions to a Roth 401(k) may reduce your taxable income in the future.
Employees contribute to their 401(k) through payroll deductions. Your employer reduces your paycheck by the amount you specify and directs that money to your 401(k) instead. The government limits the amount you can contribute each year. For 2021, the IRS set the contribution limit at $19,500 ($26,000 for those 50 and older).
Generally, unless you’re self-employed, you cannot open a 401(k) for yourself. You typically have to work for an employer that offers a 401(k) plan.
What Is 401(k) Matching?
Many employers sweeten the deal for employees who contribute to their 401(k) by offering matching contributions. These are additional contributions that don’t count toward your contribution limit for the year. In effect, they’re like a bonus deposited directly into your 401(k).
The basic concept is that for every dollar you contribute to your 401(k), your employer contributes a set amount, up to a limit. Often, you’ll hear employers quote their matching style as something like “50% up to 5% of your salary.”
That means if you contribute up to 5% of your salary to your 401(k), your employer adds contributions equal to half of the amount you put in. If you contribute more than 5% of your annual salary, your employer only contributes based on the first 5% of your salary.
For example, say you make $50,000 per year, and your employer matches 50% of your contribution up to 5% of your salary. If you contribute 5% of your salary ($2,500 per year), your employer adds an extra $1,250 per year (50% of that amount). It’s like getting free money.
If you decide to contribute 6% of your salary ($3,000 per year), your employer still only contributes $1,250 because it doesn’t offer additional matching beyond the first 5% of your salary. If you choose to contribute just 4% of your salary ($2,000 per year), your employer’s contribution drops to $1,000 because they only match based on what you put in.
There are many ways for employers to set up matching contributions. An employer may match 100% of contributions up to a set amount and then a smaller percentage after that. Some employers offer matching above 100% of your contributions. Others may contribute to your 401(k) regardless of whether you contribute, or they may not offer any matching contributions at all.
What Is 401(k) Vesting?
When an employer makes contributions to your 401(k), you may not immediately own the money. You have the freedom to invest the money your employer contributes, but until you vest in your retirement plan, your employer still owns the money it contributed on your behalf.
It’s important to note that any money you contribute from your paycheck is yours. Vesting only applies to employer contributions.
Vesting is the process by which your employer’s contributions become yours. Vesting happens based on how long you work for your employer. If you leave your employer before you fully vest in the retirement plan, you’ll have to return some or all of the money your employer contributed to the account.
Why Do Employers Have 401(k) Vesting?
Employers use 401(k) vesting as a tool to retain employees.
When a company hires a new worker, the company has to invest in training that employee on the technology, tools, and processes used to accomplish that employee’s job. If an employee accepts a job at a company, spends six months going through training, and immediately leaves for a new position, the employer wasted time and effort on training an employee without getting any of the benefits of having a well-trained worker.
By making an employee stick with the company for a set amount of time to vest in their 401(k) plan, employers can offer additional encouragement for employees to stay loyal to the company. It’s harder to decide to leave a company if doing so would cause you to lose out on hundreds or thousands of dollars in unvested retirement contributions.
Kinds of Vesting
There are multiple ways that employers can structure 401(k) vesting.
Immediate vesting is the least common vesting schedule but the most beneficial for employees. If your employer uses immediate vesting, then any contributions your employer makes immediately become your property. You never have to worry about losing out on money by leaving your job before you vest in the retirement plan.
Cliff vesting is an all-or-nothing form of vesting. Your employer chooses a time period after which employees vest in the plan. For example, your employer could set up a plan where employees vest after three years.
Once you’ve worked for your company for the specified amount of time, you fully vest in the retirement plan, and all previous and future employer contributions to your 401(k) become your property. Once vested, all of the employer’s matching contributions stay in your account even if you leave. But if you leave even one day before that date, you have to return all of your employer’s contributions.
Cliff vesting is simple in that you only have to think about one date: the vesting date. However, it leaves little flexibility for employees who are not yet vested in the plan.
Graded vesting involves a schedule of partial vesting in your retirement plan. Unlike cliff vesting, where you get to keep either all of your employer’s matched contributions or none of them, with graded vesting you can keep a portion of your employer’s contributions if you leave before you fully vest.
For example, an employer may set up a 401(k) with a graded vesting schedule where employees vest in 20% of their 401(k) each year.
If you leave before you reach your first work anniversary, you must return all of your employer’s matched contributions. If you leave after working for a full year but before you reach your second work anniversary, you can keep 20% of the employer’s contributions. If you leave between years two and three, you keep 40% of the contributions. This pattern continues until you’ve stuck with your employer for five years, at which point you’ve fully vested in the plan and all matched contributions become yours forever.
Graded vesting is more complicated than cliff vesting because you need to keep track of the schedule, and there are more significant dates that affect how much of your employer’s contributions you get to keep. However, graded vesting also offers more flexibility. You can leave your employer before you fully vest in the plan and still keep some of the money your employer contributed.
Generally, graded vesting plans require more time for workers to fully vest compared to cliff vesting plans.
What Happens If You Leave Your Job Before Your 401(k) Vests?
If you leave your job before you vest in your company’s retirement plan, your employer reclaims some or all of the money it contributed on your behalf.
It’s important to reiterate that any money you contributed belongs to you; however, your employer’s contributions only become yours once you vest. You don’t have to worry about your employer taking away money you earned and contributed out of your paycheck.
If your employer uses cliff vesting, it takes back all of the money it contributed to your account. If your employer uses graded vesting, it takes back a percentage of its contributions based on how much you have vested in the plan.
In short, leaving your job before you fully vest in your 401(k) means you have to return some of your 401(k) balance to your employer.
What Happens to Your 401(k) When You Leave Your Job?
401(k)s are employer-operated programs. You can only make contributions through paycheck deductions, so once you leave your job, you cannot make additional contributions to your 401(k). If you find a new job, your new employer may offer a 401(k) plan, but you’ll have to set up a new account with that plan’s administrator.
If you have money in your 401(k) when you leave your job, you have a few options.
Most 401(k) plans let you leave your money in the plan even if you no longer work for the employer, as long as you meet minimum balance requirements — often around $5,000. If your 401(k) plan has good investment options, such as low-cost index or target-date funds, this can be a good way to go.
Another option is to transfer the balance of your 401(k) to an Individual Retirement Account (IRA) at a broker like JP Morgan Self-Directed Investing. IRAs offer similar benefits to 401(k)s, and anyone can open one. With an IRA, you have the freedom to choose a company to hold your money, so you can invest your money in almost anything. This is a good option if you already have an IRA or if you want to invest in funds your 401(k) doesn’t offer.
Some employers also let you roll the balance of your previous 401(k)s into your new 401(k). If your new employer offers a 401(k) and you like the investment options, this can be a good way to keep all of your retirement funds in the same place.
Finally, you can take distributions from your 401(k). Generally, this is a poor option unless you’re at retirement age. If you’re younger than 59 ½, you have to pay a 10% penalty on the amount you take as a distribution. On top of that, you have to pay income taxes on the distribution if you take it from a traditional 401(k). That makes this option potentially costly.
Can Leaving a Job Before Vesting Be Worth It?
Whether it’s worth leaving your job before you vest in your retirement plan is a difficult question. It can depend on the reason you want to leave the job, the amount your employer has contributed to your account, and the vesting schedule your employer uses.
One thing to consider is whether leaving your job will let you increase your income by a significant amount. If a new employer offers you tens of thousands of dollars more per year than your current employer, it might be worth giving up on your employer’s contributions to start earning a higher salary.
Also, consider how much you’ll lose from leaving your job. If your employer only contributed a few hundred dollars that you’ll lose, that’s much less painful than losing out on thousands of dollars of employer matching.
Keep in mind how far you are from vesting in your retirement plan. If your employer uses a cliff vesting schedule and you’re years away from vesting, it’s easier to justify leaving than if you only need to work for another month or two to fully vest.
Exceptions to 401(k) Vesting
Vesting in a 401(k) plan is typically dependent on how long you work for an employer. Work there long enough, and you vest in the plan. If you leave your employer too soon, you don’t get vested and have to return employer contributions.
There are, however, some exceptions to the typical vesting schedule that are worth knowing.
Reaching Retirement Age
When your employer establishes a retirement plan, it needs to specify the plan’s expected retirement age. Typically, employers set the date roughly in line with the government’s retirement age. Age 65 is a commonly used number.
If you reach the retirement age specified in your employer’s retirement plan, you immediately become fully vested, regardless of how long you’ve worked for them or whether your employer uses a cliff vesting or graded vesting plan.
This provides an advantage to older employees who may be able to vest in a plan shortly after starting a new job.
Employer Terminates the Plan
Employers set up 401(k)s plans as an employee benefit, but there’s no guarantee an employer will keep its plan around forever. Companies have the freedom to change their retirement plans or get rid of them entirely.
If a company decides to terminate a retirement plan, it cannot recover the money it contributed on behalf of employees who are not vested. Instead, all employees participating in the plan when the employer ends it automatically vest in the plan.
401(k)s are a valuable benefit for employees, and the matching contributions employers offer make them even more valuable. Understanding the vesting process is important to make sure you get the most out of what your employer offers. It can also help inform your career plans by giving you a timeline for searching for a new job.