What Is Vesting?
Vesting is a legal term that means to give or earn a right to a present or future payment, asset, or benefit. It is most commonly used in reference to retirement plan benefits when an employee accrues nonforfeitable rights over employer-provided stock incentives or employer contributions made to the employee's qualified retirement plan account or pension plan. It also is commonly used in inheritance law and real estate.
In the context of retirement plan benefits, vesting gives employees rights to employer-provided assets over time, which gives employees an incentive to perform well and remain with a company. The vesting schedule set up by a company determines when employees acquire full ownership of the asset. Generally, nonforfeitable rights accrue based on how long an employee has worked for a company. One example of vesting is seen in how money is awarded to an employee via a 401(k) company match. Such matching dollars usually take years to vest, meaning an employee must stay with the company long enough to be eligible to receive them.
Vesting within stock bonuses offers employers a valuable employee-retention tool. For example, an employee might receive 100 restricted stock units as part of an annual bonus. To entice this valued employee to remain with the company for the next five years, the stock vests according to the following schedule: 25 units in the second year after the bonus, 25 units in year three, 25 units in year four and 25 units in year five. If the employee leaves the company after year three, only 50 units would be vested, and the other 50 would be forfeited.
For some benefits, vesting is immediate. Employees are always 100% vested in their salary-deferral contributions to their retirement plans as well as SEP and SIMPLE employer contributions. Employer contributions to an employee’s 401(k) plan may vest immediately. Or, they may vest after several years using either a cliff vesting schedule, which gives the employee ownership of 100% of the employer’s contributions after a certain number of years or using a graded vesting schedule, which gives the employee ownership of a percentage of the employer’s contribution each year. Traditional pension plans might have a five-year cliff vesting schedule or a three- to seven-year graded vesting schedule.
Just because you are fully vested in your employer’s contributions to your plan does not mean you can withdraw that money whenever you want. You are still subject to the plan’s rules, which generally require you to reach retirement age before making penalty-free withdrawals.
[Important: Employees are always 100% vested in their own contributions to an employer-sponsored retirement plan.]
Vesting is common in wills and bequests and often takes the form of a set waiting period to finalize bequests following the death of the testator. This waiting period before vesting helps reduce conflicts that could arise over the exact time of death and the possibility of double-taxation if multiple heirs die after a disaster.
Startup companies often offer grants of common stock or access to an employee stock option plan to employees, service providers, vendors, board members, or other parties as part of their compensation. To encourage loyalty among employees and also keep them engaged and focused on the company's success, such grants or options usually are subject to a vesting period during which they cannot be sold. A common vesting period is three to five years.
- When an employee is vested in employer-matching retirement funds or stock options, she has nonforfeitable rights to those assets.
- The amount in which an employee is vested often increases gradually over a period of years until the employee is 100% vested.