401(k) Vesting Schedule: Cliff vs Graded [+ Examples]

Cody Cromwell
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How a 401(k) Vesting Schedule Works

401(k) vesting schedules are used to determine the rate at which investment company shares will be put into an employee’s account. This rate will determine when the employee will receive full ownership of company stock. However, some companies opt to have a cliff vesting schedule that starts at 100% and gradually reduces to 0% over time.

401(k) vesting schedules are also used to determine the rate at which company stock is returned to an employee in the case of the retirement of the employee. This means the vesting schedule can also control the rate at which the employee can claim company stock when leaving his job at the job.

Employee Benefits for Employers
Benefits for employee’s 401(k) retirement plans can include increased membership costs for the company’s employees, increased employee productivity, increased employee retention, and increased cash flow for the employer (as a direct result of the contributions made).

Employee Benefits for Employees
Employees of companies with 401(k) retirement plans are able to save their money in the plan, earn a return on their investment of the company’s money, and potentially collect full ownership of the company’s stock.

Employer consideration regarding vesting is important, as this can determine how much company stock the employee will own in the future.

Immediate Vesting

Vs. Vested 401(k) plans

401(k) plans are a tax-advantaged retirement savings vehicle that offer up to 100% tax deferral until the money is taken out after retirement.

Plan administrators have two options when it comes to the amount of 401(k) plan vesting. The first option, known as immediate vesting, is for plan participants who want their funds immediately. The most common example of this is when a corporation (or other employer) reduces the amount of interest it pays on loans it receives from a bank. Some of that interest is be paid into the 401(k) plan as distributions, and the employer has the option of electing to make that interest pay into the plan immediately or defer that interest until it is removed by the employee.

It’s important to note that if the employer elects to defer interest, any gains will be fully taxed as ordinary income at that employee’s highest marginal tax rate when the debt is paid off.

The second type of 401(k) plan vesting is known as graded vesting, and this is what you see the great majority of 401(k) plans operating under. With graded vesting, the amount paid out over time decreases as an employee advances towards plan retirement.

Graded Vesting Schedule

VS. Cliff Vesting Schedule

There are specific rules to determine the vesting schedule in your 401(k) plan. Typically, employees contribute to these plans with pre-tax dollars. After they’ve reached a certain number of hours (20, if you’re under age 50), their contribution will be made post-tax. So, when you start contributing to the plan, there’s a chance that your employer will first match a portion of your contributions. This gets added to your pot of pre-tax vs. post-tax dollars. Over the years, there could be a lot of pre-tax money in the pot you’ve accumulated. But when it comes time to get your retirement inheritance, the money will be taxed at your income tax bracket.

A graduation or cliff vesting schedule is a special arrangement often used by some employers (and usually by self-funded plans) to take advantage of the tax advantages of the pre-tax money.

The following table shows the equivalence between the cliff and graded vesting schedule:

Cliff Vesting Schedule Graded Vesting Schedule For each year, X% For each year, Y% X Y X = 10 year cliff X = 10 year graded

Cliff Vesting Schedule

The standard cliff vesting schedule means that as long as the plan meets its vesting requirement, 100% of the account value is vested on the same day, and all vested accounts are 100% vested, regardless of the age of the vested account.

With a cliff vesting schedule, all vested accounts are 100% vested immediately, without any distinctions. This means that you earn the same payouts regardless of the age of the vested account.

There is one exception in terms of when cliff vesting occurs and when the investor’s account begins to earn interest. Cliff vesting does not occur until 6 months after the last of the Liftoffs occurred. Liftoffs are dates when the plan first met vesting requirements and became 100% vested.

With this standard cliff schedule, if a plan has Liftoffs on Dec. 31, 2000, Dec. 31, 2001, Dec. 31, 2002, and Dec. 31, 2003, then cliff vesting would occur on April 1, 2005. However, if the plan has at least four more Liftoffs after Apr. 1, 2005, cliff vesting would occur on the earlier of:

The earlier of Apr. 1, 2006 and the date that the plan has at least four more Liftoffs; or

401(k) Vesting Schedules: Cliff vs. Graded

401(k) plans are pre-tax investment accounts that are considered retirement income accounts. Participants in 401(k) plans establish their own accounts, invest their own money, and, with some limitations, decide how to invest their money. They can choose to invest in stocks, bonds, or money market instruments, among other things.

401(k) plans are taxed each year on retirement income. So if you are invested in 401(k) plans and want to stay on the right side of tax law, it is a good idea to make sure your investment income goes into tax-deferred retirement plans.

401(k) plans in which participants defer at least some of their included dollar amounts will be considered "qualified plans" under the Internal Revenue Code, termed Section 401(k) Plans. And in order to avoid penalties and the disallowance of current tax deductions on retirement income, participants should account for these funds as soon as reasonably practicable (immediately or when the assets are higher than the required minimum accounts receivable balance). This is because a distribution (forfeiture of investment value) from a qualified plan is considered an early distribution and will trigger tax, penalty, and tax-deduction disallowance issues.

401(k) Vesting Schedule Examples

Cliff vesting: The employer contributes 100% to the account. Participant’s first 100% vest after a period of time, usually five or more years.

Graduated vesting: The employer contributes 50% to the account. Participant’s first 50% vest after a period of time, usually two to five years.

So, when talking about 401(k) vesting schedules, what’s the difference between a cliff and a graded vesting schedule?

401(k) participants can automatically start receiving vested distributions from their 401(k) accounts after a period of time; however, you can also extend the vesting period. For example, if you are vested in IRA Mode after five years, your employer contributions will be automatically vested as well.

In order to receive vested funds, participants must meet vesting conditions – usually a certain number of years of service or a certain dollar amount of eligible service. For example, companies may require two or five years of service to receive vested funds (this is known as cliff vesting). On the other hand, they may require five years of service to receive vested earnings (this is known as graded vesting).

Immediate Vesting Example

In the post "401(k) Vesting Schedule: Cliff or Graded" I discussed my understanding of the cliff arrangement where you immediately vest in your 401k after you leave your employ. Below I provide an example of a cliff arrangement for a company with 2 10% vested balance options.

Cliff Length

This method of vesting works best when your company has a longer cliff length. The amount of time it takes to contribute towards the vested balance will increase, but the percentage of your vested balance you earn every year will remain the same.

Let’s say the corporate policy calls for a 20% cliff length and the vesting schedule calls for 20% to vest each year. Because it is 20% cliff length, 20% is immediately vested in the first year.

For the 2nd year, suppose you contribute 10%. After 1 year, your company allows you to contribute another 10%. Only this time instead of contributing 20%, it will only contribute 10%.

After a total of 2 years and now with a yearly accumulation of 14.26% (1 of those years was 20% on top of the 8% from the previous year), you will now have 16.26% vested in the second year and will contribute another 8% towards that.

This is the most tax efficient way to accummulate in the corporate 401(k) plan.

Cliff Vesting Schedule Example

A cliff vesting schedule allows the participant to have 100% ownership of their vested account balance, as soon as the vesting period ends regardless of the account balance at the end of the vesting period.

Usually, cliff vesting schedules provide for an increase in ownership, but not at the same period. Typically a guide is a formula that specifies the percentage increase of the percentage for each account balance.

The amount to be vested at the end of the cliff vesting period is a percentage of the participant’s account balance (plan or account balance). Typically, only the vested percentage is allowed to remain on the account balance. However, some plans allow the excess amount outside of the vested percentage to remain in the account balance.

For example, Vested Interests in Employees (Pension) Plan gives an administrator the option to vest the entire account balance of the employee at the end of the vesting period or to vest at a rate of 5% per year for 5 years.

Graded Vesting Schedule Example

401(k) Vesting Schedule Costs

There are two general types of vesting schedules in 401(k) plans: cliff schedules and graded vesting schedules.

A cliff vesting schedule means that vested participants’ benefits are 100% vested on the date they are granted, with no additional vesting schedule. Once you are vested, you have 100% vested immediately.

With a graded vesting schedule, benefits vest at different times during the vesting period; the smaller the percentage, the faster the vested percentage reaches 100% at the end of the vesting period.

401(k) vesting schedules are generally based on years of service, which is standard for most employer retirement plans. 401(k) plans with cliff vesting schedules vest 100% after one year of service, with no cliff after that.

With graded vesting schedules, the benefits vest 20%/year after one year of service, with no cliff after that. To see the effect of a cliff vesting schedule on 401(k) plan costs of waiting, check out this study from Morningstar.

NOTE: A distinction can be made between 401(k) plans that offer a cash match and those that don’t. If a 401(k) plan offers a match, participants will be 100% vested after one year of service regardless of the vesting schedule used.

Cliff Vesting Schedule Costs

More?

Vesting schedules are provided by 401(k) plans to be used as a tool to convert employees from non-401(k) to 401(k) employees; or more commonly from new hire to active employee employees (those with vested) to total (all) employees. Plain Cliff Vesting schedules last only until employees reaches the age of 55.

Graded Vesting Schedule Costs Less?

While Cliff Vesting schedules cost more, graded vesting schedules cost less, when a company wants its employees to stay with the company for the long term. It generally is recognized by the Department of Labor, are less expensive, as they increase the percentage of vested shares that an employee acquires through the length of service, often pegging it at 25%, 30%, 35%, or even 40%.

However, a well-designed vesting program that offers the correct amount of stock to incentive a worker toward a longer service time may in fact outperform the cliff program, according to a study by Wilton and Associates.

Why do Cliffs Cost More?

When using a cliff vesting schedule, vesting occurs after serving just three years. Cliff vesting schedules determine the amount of vested shares an employee reaches by the particular percentage of service time up to a set age and thereafter determines mixed vesting.

Graded Vesting Schedule Costs

401(k) plans usually vest (i.e., become an employee’s equity right and ownership) after a specific service period (usually five years). After the initial vesting period, the employee usually has a number of years left before the plan’s minimum percentage of vested, which is basically the employer’s percentage of ownership. This is the cliff (or graded) vesting schedule.

The cliff vesting schedule is probably the most widely used. Under this vesting schedule, the employer’s percentage stays the same for the first number of years, making the cliff vesting schedule cheaper to administer, since the minimum vesting percentage doesn’t need to be calculated at the beginning of each year. And in these years, the employee would not be entitled to vested, and, at that point, the ratio of the employee’s ownership in the company would be 1 percent to that of the employer.

401(k) Vesting Rules

This post should get you up to speed on 401(k) vesting schedules for the year. If you need help with your 401(k) or 457(b), let me know! I’ve worked with clients on their retirement plans for years and can help you make sure you get just the right amount of tax-deferred compounding income to meet your retirement goals.

401(k) Vesting Schedule

Vesting schedules determine the percent of your vested 401(k) plan as a percentage of your employer’s total contributions to the plan, as well as the percentage of your vested balances that you must remain invested before beginning to receive distributions.

Vested 401(k) plan balances are those that you are credited for, but have yet to actually receive in the form of future distributions. The percentage of vested balances that must remain invested increases over time. Vesting schedules are often expressed as percentages though can be expressed in different units such as vested full shares, vested dollars, or vested days to earn.

There are four basic vesting schedules commonly used in 401(k) plans:

401(k) Vesting Schedule Pros & Cons

Cliff Vesting or Graded Vesting?

Generally speaking, there are two ways that companies choose to vest or vesting a 401(k). These are cliff vesting and graded vesting.

Cliff vesting is when a participant starts to vest a percentage of their account funds each year. This percentage may appear to be low or large initially but can gradually vary to be very substantial over time as more funds are invested into the account.

A graded vesting schedule is when the percentage of the account that is vested increases each year. This can be a steady increase for the entire period or may ramp up dramatically at the beginning but then slowly taper off.

If you are unsure of the difference between these two types of vesting schedules, it is probably best to consult with a financial or HR professional.

As a participant, you will likely only receive a simple, quantitative statement that tells you the vesting schedule that was established for your account. You may not even know how much your account is worth or how much you will receive unless you dig deeper into the account.

It is also important to note that vesting schedules can vary by job position or by how much each employee contributed to your account. Your vesting schedule may differ from your colleagues but is typically similar to the vesting schedule that was set for your position.

Pros of Using a Vesting Schedule

By setting aside money in your 401(k) for vesting, you're investing in your own future as well as the future of your company. Creating a vesting schedule for your 401(k) plan lets you do that without incurring the high fees usually charged by funds of funds or other managed products. And, because of that, once you're vested, you can opt for a simpler plan.

Deciding what to put in a 401(k) survey or plan and setting aside enough to create a vested account are two very important decisions. While it’s important to carefully manage your investments, you should invest in yourself, too. Plus, when you choose your investment options, you could be setting aside a nice nest egg for retirement.

401(k) vesting schedules help reduce costs.

The fees associated with using a 401(k) plan are huge, especially if you are investing more than 100% in equities. In that case, many people use a 401(k) plan because they don’t want to pay the trading commission because they are buying and selling specific stocks.

Vesting schedules help you avoid these fees by only investing in the companies you work for. By making the money you’ve accumulated available to you after X number of years, you will reduce the amount of money you would have to pay in fees.

Cons of Using a Vesting Schedule

The problem with vesting schedules isn't just that they take a great deal of management from the company. It's also more of an administrative hassle than it's worth. Instead of handing each manager the responsibility of an individual account, at a company that has a vesting schedule, each manager has to do it for the whole team. It doesn't make sense to hand the responsibility over to one guy in a particularly small team if it means allocating a lot of team resources to it.

Vesting schedules also demand a certain level of trust between employer and employee. Changing the vesting schedule of a company often requires a vote, and at a union bargaining unit the vote doesn't always take place. Any vesting schedule that isn't approved in a formal meeting isn't likely to happen.

This makes it hard for companies and employees to agree on vesting schedules because of these administrative headaches. In some cases, employees are willing to give up a portion of ownership to get vested ownership sooner, and the company is willing to make that happen if they can cut down on administrative duties. Both sides give out a bit and the arrangement is made. In other cases, such as at Yahoo!, sites that are notorious for giving out huge vesting schedules, these vesting schedules are blocking a huge amount of potential for an employee to own a significant stake in the company.

Pros of Cliff Vesting Schedule

Cliff-vesting provides employees maximum flexibility to take advantage of employer matching contributions, while most companies do not allow employee contributions beyond the contributions made by the employer, and a cafeteria plan allows employees to allocate vested funds to other than the employer’s matching contributions.

This is a win-win for both employers and employees. Employers can offer a more attractive compensation package; employees have more retirement savings options, which reduces the chance of outliving their retirement savings and employees who, for whatever reason, cannot contribute to their own accounts for a particular year (for example, because they’re too young or because they’re expecting a pay raise and want to defer the employer matching contribution to a subsequent year) can defer by simply not contributing.

If the employer provides a 6% tax-deferred option, the employee can elect for that option if desired, instead of having to use a portion of their pre-tax dollars to contribute.

Cons of Cliff Vesting Schedule

The treble tax is the amount of tax that is paid by an employee when they separate from service. Americans have to pay this tax, which is typically 2-3 percent of the vested distribution, when they are laid off. When a pension plan uses the cliff vesting schedule, it means that the employee does not have to pay the treble tax until a certain period of time, or a cliff, has lapsed.

Generally, the employee has to be with the company for 18 months to qualify for the tax-free portion of the distribution. In the case of a partial distribution, the employee must remain with the company for 12 months. There is a lot of talk about how this means that employers should look for ways to keep employees from leaving the company to avoid the treble tax on their pension.

But the simple truth is that if you are planning to terminate an employee, they are likely to find another job pretty quickly. So you’d be better off forgoing using the cliff vesting schedule and offering them the full pension right away and hoping that they don’t jump at the chance to take the cash.

Pros of Graded Vesting Schedule

Review the 401(k) vesting schedule by the company explaining the benefits of their 401(k) plan over other competitors.

Draw up a comparison of the benefits in 401(k) plans and other finance benefits on business cards.

Draw up a comparison of 401(k) plans on business cards.

Showing interest in 401(k) plans can encourage the business to look more deeply at investing in your 401(k) plan.

It can help to additionally advertise to hire employees to help promote the 401(k) plan.

Provide a plan to educate the employees on where their money goes.

If there are further costs related to the 401(k) plan, it is beneficial for the business to be able to pay in full for the employee's benefit.

Human resources can be a valuable marketing tool when it comes to the human resources department. The more that the employees are bought in to 401(k) plans, the higher the retention rate will be.

Once employees have vested, the company can then sell the rights to the plan (this is also known as purchasing the plan from the employee). At this point, the company is then able to reap the monetary benefits of their contributions without having to anymore administrate and fund the plan.

Cons of Graded Vesting Schedule

Some employers use various vesting schedules, while some do not use them at all. Employers may set up vesting schedules many different ways. This method is somewhat controversial, and is sometimes known as a cliff vesting schedule.

Cliff vests vest for a set number of years, and then vests at a set percentage until they reach the end of the vesting schedule. For example, an employee who signs up for a three-year vesting schedule will have all opportunities vest after the initial three years. If this person leaves before being fully vested, they won’t get any vested stock or benefits for the remaining vesting period.

This vesting schedule method lets employers set a cliff distance that specifies the percentage the employee will have to vest by. This cliff distance is typically applied to the employee’s original qualifying date (QD).

For example, an employee who was hired in the 3rd year, March 9th, 2002, would have to own, or be eligible for ownership, of 50% of the company’s stock or options by the end of the year, March 9th, 2004.

On March 9th, 2004, the employee would vest 100% of their stock and options. If the employee was successful in reaching these vesting goals, he or she would then get monthly options grants.

Frequently Asked Questions (FAQs)

Q. What is the difference between a cliff vesting schedule and a graded vesting schedule?

A. Both cliff vesting and graded vesting schedules work the same way. A cliff vesting schedule stipulates that only a certain percentage of the shares of stock you own are vested immediately. Shares that are not vested are held in a common trust fund and are not available to you for any reason until they are vesting. With a cliff vesting schedule, you vest gradually over a period of years. In contrast, a graded vesting schedule stipulates that the shares are divisible and therefore vested immediately.

Q. What is the difference between a graded vesting and a cliff vesting schedule?

A. Both graded vesting and a cliff vesting schedule provide you with a vested percentage of your shares based on when the shares were acquired. This percentage of vested shares is reviewed and may change with your company’s performance and/or your individual success. When your shares vest based on a graded schedule, you vest right away and the vested shares become available immediately whereas a cliff vesting schedule has some percentage that vest after completion of a time period.

Q. How are 401(k) vesting schedules verified?

What Is a Vesting Period?

Are Contributions from Different Years Vested Separately?

In general, 401(k) plan contributions are vested according to the vesting schedule in the plan document. The plan document is basically your retirement plan’s rules (a.k.a. the 401(k) plan document). In general, there are two types of plans, time-based and graded. With time-based plans, you are required to contribute for a certain number of years before your retirement date (known as the service period, typically ranging from three to seven years), before you have the right to withdraw the amount you contributed. With graded plans, there is no set contribution period.

With traditional 401(k) plans, you may have multiple time-based contributions with different service periods, i.e. different years, during which you are potentially entitled to different percentages of the vested accrued balance. Traditional 401(k) plans do not offer graded contributions.

However, with Roth 401(k) plans, vested funds are usually distributed to the account holder according to the following table:

The amount of your contributions, investment earnings, and any employer contributions are included in this table. Generally, with traditional 401(k) plans, contributions made before you reach the age of 50 must be paid in a lump sum upon separation from service.

When Are You Not Allowed to Use a 401(k) Vesting Schedule?

A 401(k) plan is the type of retirement savings account that you typically set up at work. You decide how much money you want to contribute to the account and then decide how that money should be invested. The goal here is to come up with a plan that will be both comfortable for you when you retire … as well as lucrative for your employer.

The catch here is that you need to start withdrawing your money when you reach a certain age, because you don’t want to be making a large withdrawal right before retirement. That’s where the vesting schedule is so important.

The vesting schedule is a set of dates when you are allowed to withdraw all of your money. Usually, these dates are staggered … with you getting a little bit of money every year until the account is "fully vested." The exact dates typically depend on how much money you put into the 401(k) in the first place.

Although vesting schedules can vary a bit, you can usually expect a weighted vesting schedule if you put in a large sum of money.

Furthermore, if you work at a large company, then you can expect your vesting schedule to be longer than the typical employee’s vesting schedule.

Finally, people who put in a lot of money typically get much higher percentages of their money back.

Can a Plan Change to Immediate Vesting?

401(k)s are retirement income plans that allow employees to save pre-tax dollars (before taxes) to eventually build retirement income (for individuals that retire pre-Social Security age). The benefit of a 401(k) plan is that the employer and employee split the plan expenses, so the contribution does not affect the employee’s taxable income. Also, the most common benefit of a 401K plan is that the employee just contributes after tax dollars to build retirement income.

The disadvantage of a 401(k) plan is taxpayers must pay income taxes on the contributions, although if they participate in a 401(k) plan, they do not receive annual income tax credits.

In addition, all 401(k) plans contain a vesting schedule that dictates when the employer and employee have and do not have complete ownership of the money contributed. As an employee, you are invested in the money when you contribute and also have some if the ability to receive the funds if you leave (ex. in the case of a Bonus) or if you become unemployed (without a retirement plan with an employer). In the case of a lump-sum windfall, you are the one who can receive the money at any time.

401(k) benefits are commonly set up in the following manner:

  • Half vested in three years
  • Unvested 30% within five years
  • Unvested 50% within ten years

What Does It Mean to be 100% Vested?

  • 100% vested … you own 100% of your company’s stock so your percentage ownership is not reduced
  • 100% vested … all your vested stock is fully paid for in dividends; no more company shares or options will ever be issued to you
  • 100% vested … the only way you lose your stock is if you sell it
  • 100% vested … if you leave the company, you lose any company stock you don’t yet own
  • 100% vested … the company can’t issue more shares to you.
  • 100% vested … you keep 100% of the appreciation

Bottom Line

401(k) Vesting Schedule When you invest money in a 401k plan, you receive employee deferral and employer matching contributions. The amount is taxed (depending on the type of 401k) and then invested based on your financial and investment goals into investments (for example stocks, real estate, precious metals, etc.) for retirement, in order to provide your retirement fund with the return necessary to sustain the necessary retirement financial support.

S tax deferred worksheet as well as your account balance and receive a Vesting Schedule Report when your account reaches a certain balance that allows you to withdraw money. The basic explanation of the planning is that the employer and employee defer a portion of your salary and contribute to the 401(k). Of that sum, the employer matches up to 2.0% of your salary, and you contribute up to 17.5% of your salary. Income tax is deferred until withdrawals are made.

When an employee leaves the company, the employer should roll over the vested portion into an IRA. That is, when the RMD formula (Required Minimum Distribution) is met, the employer does not have to roll anything over into an IRA. When the employee leaves the company, the employer must prepare a Form 5498 tax-free rollover and submit it for that distribution.