Vesting
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VESTING
Vesting refers to the employees ownership of the retirement savings in a qualified plan. To become tax-qualified, the 401k  plan must satisfy the minimum vesting standards provided under ERISA and in the Internal Revenue Code.

Accumulated savings in a 401k  plan are generally the result of:

employer contributions,
earnings on employer contributions,
employee contributions,
earnings on employee contributions, and
amounts allocated from plan forfeitures.

Qualified plans must contain a vesting schedule that will provide the employee with increasing ownership in the employer's contributions and all earnings in the plan.  The schedule is based on the employee's length of service.  Eventually, the employee owns all of the retirement savings in his or her account. At that point, the employee is "100% vested" and the employee's right to retirement benefits becomes "nonforfeitable".  Vesting may be immediate or deferred.  In the case of deferred vesting, the employee must wait a specified period of time before having access to the benefits in plan.  If a benefit is immediately vested, the employee is entitled to the benefit once the funds have been contributed to the retirement plan (Please note: just because the benefit is vested mean that the benefit can be distributed without restriction -- it simply means that the employer cannot withhold the benefit from the employee.   For example, the tax code may penalize a withdrawal prior to age 59½).  
Deferred vesting provides a powerful incentive to continue working for the same employer in order to enjoy full retirement benefits.  From an employee's perspective, the plan's vesting schedule determines the amount the employee can expect to receive from the plan if employment is terminated or the employee retires -- and it limits the amount an employee may borrow from the plan.


Employee Contributions

Deferred vesting schedules relate to retirement benefits arising from employer contributions and earnings on those contributions.  Mandatory or voluntary employee contributions to a plan are not subject to these vesting schedules. All employee contributions (and the earnings on those contributions) are immediately and fully owned by the employee, i.e., "100% immediate vesting".

The tax code requires "full and immediate vesting" for the following types of contributions to a 401k plan:

contributions made by an employer pursuant to an employee's election (elective contributions),
voluntary after-tax contributions made by an employee,
any other contributions taken into account in computing employees' actual deferral percentages (ADPs) in meeting non-discrimination requirements; and
rollovers and transfers from other qualified plans.
In addition, all income earned from any of these contributions also must be fully and immediately vested.

All other contributions (and resulting income) may be vested under a deferred vesting schedule.


Deferred Vesting Schedules
In the past, employers used long vesting schedules in an effort to reduce turnover.  Such plans for employers with high turnover rates resulted in large forfeiture of benefits, which in some cases, reduced the employer's future contributions. Since 1989, employers must vest benefits no slower than the two methods proscribed in the tax code:

five-year vesting  (cliff vesting), or
three-to-seven-year vesting (graded vesting).

Keep in mind, employers may vest employee benefits faster than these schedules, but not slower.  The shorter the period of service required, the larger the vested percentage and the greater the cost of the plan to the employer.

The five-year vesting schedule is sometimes called "cliff" vesting,  because an employee can be 0% vested in the first four years and fully 100% vested in the fifth year. If the employee quits before the fifth year, he or she gets nothing -- in other words, all of his or her retirement benefits are forfeited.

Using this option, the vested percentage can be 0% for the first four years, or it could be 20% each year for five years, or 50% after 3 three years, etc. The employer can select any percentage so long as the employee is 100% vested after five years.

MINIMUM 5 YEAR CLIFF VESTING
Vested
%age
100%
VESTED BENEFITS
80%
60%
40%
20%
0%
Years of Service
0
1
2
3
4
5
6
7
8
9
10


Three-to-seven-year vesting, is also called the"graded" schedule, since it requires a gradual phase-in of retirement benefits between years 3 and 7: 20% vested in year 3, 40% in year 4, 60% in year 5, 80% in year 6 and fully vested in year 7.

3-7 YEAR GRADED VESTING
Vested
%age
100%
80%
60%
VESTED BENEFITS
40%
20%
Years of Service
0
1
2
3
4
5
6
7
8
9
10

Example: Geoff Striker participated in a qualified plan for six years.  When he quit, his profit-sharing account amounted to $20,000. If the  plan uses the minimum three-to-seven-year vesting schedule, Striker would be entitled to $16,000 (80% of $20,000).

As with the cliff vesting, employers may accelerate the graded vesting percentages, but not extend them.

Amounts forfeited by departing employees may be applied to reduce employer contributions (this is typical in defined benefit plans) or the forfeiture may be allocated among remaining employees as an additional contribution (in defined contribution plans, such as 401ks).



New vesting schedules

Prior to 2002, all employer-provided benefits had to vest at least as fast as under one of the above vesting schedules.  Beginning in 2002, special, faster vesting schedules apply to monies contributed to 401k plans by employers as matching contributions.  Beginning in 2007, an employer's non-elective contributions must also vest under the accelerated schedule.  Previous contributions may continue to vest under the older, slower schedules -- or to simplify administration of the plan, employers can choose to apply the faster schedule to all previous employer contributions.  (Forfeitures may continue to vest under the older schedules in the future. And of course, employee contributions to 401k plans remain fully and immediately vested. )

Under the new schedule, employer contributions must vest no later than:

a 3-year cliff schedule or
a 2-to-6 year graded schedule.




Top-Heavy Plans

Plans that disproportionately benefit key personnel are "top-heavy".  A  "key employee"* is any current employee who, at any time during the plan year:

was an officer earning more than $145,000 a year (in 2007),
owned more than 5% of the employer, or
owned more than 1% of the employer and earned more than $150,000 a year (not indexed for inflation).

A 401k plan becomes "top heavy" when the value of the combined accounts of key employees exceed 60% of the total plan -- or the total contributions on behalf of "key employees" exceed 60% of the total contributions to the plan.

Example: Bob Burns owns a small advertising company  with two employees. His company has a defined contribution plan and made contributions amounting to:

Employee           Contribution
Bob Burns                $12,000
Employee #1            $  5,000
Employee #2         $  3,000
Total Contributions   $20,000      

Assuming Burns is the only key employee, the plan is not top-heavy. The total  employer contributions for key employees (Burns) is exactly 60% of the contributions made for all employees. The total contribution for all three employees was $20,000, and Burns' share was $12,000 ($12,000 / $20,000 = 60%). For a plan to be top-heavy, more than 60% must be contributed for key employees.


In "top heavy" plans, the vesting schedule is accelerated.   This means that non-key employees are entitled to their 401k benefits at a faster rate if the plan is top-heavy.   Top heavy plans must comply with a more rapid vesting schedule:

3-year cliff vesting, or
2-to-6-year graded vesting.



MINIMUM 3 YEAR CLIFF VESTING
Vested
%age
100%



VESTED BENEFITS
80%
60%
40%
20%
0%
Years of Service
0
1
2
3
4
5
6
7
8
9
10

2-6 YEAR GRADED VESTING
Vested
%age
100%
80%
60%
VESTED BENEFITS
40%
20%
Years of Service
0
1
2
3
4
5
\6
7
8
9
10


In addition, top heavy plans are required to make minimum employer contributions for "non-key" personnel.  The employer must match "non-key" employee deferrals with a percentage equal to the highest percentage deferred by any "key" employee, up to a maximum of 3%.   In practice, a 3% contribution is usually required.

If a plan is top-heavy in one year, but reverts to "regular" status in later years, the vesting schedule also reverts to the "regular", slower schedule.  However, any matching contributions or benefits vested under the faster, top-heavy schedule remain vested with the employee.



Plan Termination

As a general rule, qualified plans -- including 401k plans -- must be permanent. However, employers are allowed to discontinue or scale-down a plan for a variety of business reasons. Out of business necessity, a plan may be completely or partially terminated.

The most important consequence of either a partial or complete plan termination is participants immediately become 100% vested. Under defined contribution plans, including 401k plans, any nonvested amounts are generally reallocated to the accounts of remaining participants. This practice favors highly compensated employees because they usually work the longest for the employer.

Example: Olivia Stone has four years of service and  is 40% vested in the $20,000 balance in her firm's 401k plan.  If  the plan is terminated, Stone is entitled to all $20,000 because she becomes fully vested upon the plan's termination.