What is Unconditional Vesting
Unconditional vesting is a status reached by an employee, whereby benefits given conditionally are fully realized and cannot be revoked. Vesting, in the sense of a retirement plan, means ownership. Benefits which have vested are owned by the employee fully. Workers may be required to stay with a company for a number of years, or fulfill other requirements before benefits become unconditionally vested.
BREAKING DOWN Unconditional Vesting
Unconditional vesting is a status that is bestowed upon employees for meeting certain requirements, like length-of-service requirements. Since a company uses pensions as a tool for long-term retention of employees, a worker's entitlement to present or future pension benefits may be contingent upon continued employment with the company for a specified period. Once this condition is satisfied, the pension benefits vest unconditionally with the employee.
For example, an employer offers a 401(k), defined-contribution retirement plan to its employees. To incentivize employees staying with the firm for a long period of time, the employer pays contributions into the account every month, but these contributions don’t become fully vested initially. Instead, the employer doles out benefits using a 5-year graded vesting schedule, with the worker earning 20 percent of the paid benefits each year they work. After four years in this example, 80 percent of the money paid into the account would belong to the worker, if the worker leaves the company for another employer. 80 percent of that money would be unconditionally vested.
Cliff Vesting vs. Graded Vesting
Employers will offer conditional benefits using cliff vesting or graded vesting methods. With cliff vesting, benefits become unconditionally vested all at once. For instance, a worker may receive stock options after serving for a certain number of years. Under the graded vesting method, benefits will become unconditionally vested gradually over time, or as certain milestones are met.
Unconditional Vesting and the Taxation of Benefits
Employees are not typically required to pay taxes on unconditionally vested benefits, because those benefits are typically tax free to begin with. For instance, contributions paid to employees' retirement accounts, like a 401(k), are not taxed by the IRS and therefore go untaxed when those benefits vest. Stock-option incentives also go untaxed when they vest, though you may pay capital gains taxes on stocks sold after the option is exercised. In the case of non-statutory stock options, you will pay tax on the difference between the strike price of the option and the market price when the option is exercised.