What is a 401k?
A 401k is an employer-sponsored retirement account where employees can contribute a set amount or a percentage of their wages into an investment account which can then be used later for retirement. The investment options will vary based on the employer, but will typically include a range of mutual funds or stock options.
While not required, many employers match a portion of employee contributions. The matching contribution is often set as a percentage of wages up to a maximum percentage.
For example, if an employee contributes 5% of their wages and the employer has matching contributions of 6%, the employer’s contribution would only be 5% because it would match the employee contribution. Increasing the employee contribution to 6% would maximize the company match.
The employer contribution is a significant benefit provided by an employer. It is money above and beyond the employee’s wages and it is provided as an incentive for the employee to both plan for retirement and to stay employed at the company.
For example, an employee earning $50,000 per year and her own contributions are 5% of her wages, and with the employer match of 5%, then the employee is contributing $2,500 of her wages, pre-tax. The employer is contributing another $2,500 of company funds to the employee’s retirement plan.
If the employee works at the company for 20 years, and not taking into consideration any investment gains or losses, the amount in the retirement account after 20 years is $100,000. Half of that was contributed by the company. $50,000 of that retirement account is free money, a gift from her employer, for use during the employee’s retirement.
What Does it Mean to be Vested?
Vesting is a process in which something is earned. In the case of a 401k, this term applies when the employer contribution transfers ownership from the company to the employee based on achieving a specific goal.
For example, if an employer put an extra $1,000 (above and beyond the employee’s pay) into an account with the employee’s name on it, but then told the employee that he could have $100 of the $1,000 after working for 30 days, and he could have the whole amount after working at the company for 90 days. The time frame of 30 days and 90 days is the vesting schedule. Reaching the goal, earning the full amount of $1,000, which occurred after working 90 days, means that the employee is now fully vested.
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4 Critical Things To Know About 401k Vesting Schedules
- Employee Contributions Are Always Owned by The Employee
When it comes to contributing money to a 401k plan, the amount contributed by the employee is always owned by the employee. For example, if an employee contributes $100 per paycheck and then leaves the company after receiving six paychecks, the $600 in the 401k belongs to the employee. However, the employee cannot access the funds in the 401k until he or she reaches the age of retirement as set by the Internal Revenue Service (IRS).
- Vesting Schedules Are Set by The Employer
Vesting schedules vary from company to company. They are set at the time the company creates its 401k plan. The vesting schedule is included in the plan documents. Most companies distribute summary plan descriptions (SPD) instead of the full plan because the full plan is very long and consists significantly of regulatory information relevant to the company’s management of the plan. Much of the content in the plan document would be useless to employees.
- There are a Variety of Vesting Schedule Types
Vesting schedules protect employers in the event the employee leaves the company after a short amount of time. Employers want to offer retirement benefits. And often, they are willing to contribute to the employees’ account balance. They also want to encourage employees to stay at their company. Vesting schedules allow the employer to reward the employee’s years of employment. There are three types of vesting schedules.
- Immediate Vesting
Immediate vesting is not typical in a 401k plan. Immediate vesting means that the employee has full ownership of a specific asset regardless of the number of years of service at the company. Immediate vesting is found in simplified employee pension plans (SEP) and deferred-salary retirement plans.
In 401k plans, it is far more common that number of years of employment are rewarded by a vesting schedule that gives full ownership of the employer contribution after a set period of time.
- Cliff Vesting
With cliff vesting, the employer’s contributions become fully vested over a short time. For example, the employee might have 0% vested after one year of service, 0% after two, 0% after three, and then 100% after the fourth year. Another cliff vesting schedule might be that the employee has 10% vested after the first year, 20% after two years, 30% after three years, and then 100% after four years.
Three-year cliff vesting is another common vesting schedule found in small businesses. These plans have zero percent vested until the third year, and then after the third year of employment, the employee is fully vested.
- Graded Vesting
Graded vesting schedules have a set percent vested annually over a period of time. For example, 20% per year. After five years the employee is fully vested. In some cases, the employer may have a one-year deferral in matching and then start the graded vesting which would mean that the employee would be fully vested after six years. With graded vesting, the percentage of the company match that is vested applies to each dollar of the company match at the time the goal is reached.
- Ending Employment Before Fully Vesting Will Decrease 401k Account Balance
When an employee leaves a company before becoming fully vested the amount in his 401k will be decreased by the amount that was not yet vested.
For example, let’s look at the following circumstances:
Vesting schedule: 20% per year
Employee contribution: $3,000 per year
Employer contribution: $1,000 per year.
Length of employment: two years
Account Balance Before Terminating Employment: $8,000*
$3,000 per year multiplied by two years is $6,000 which was contributed by the employee.
The entire $6,000 is included in the employee’s account balance.
The employer contributed $1,000 per year for two years for a total of $2,000.
After two years of employment, the employee is 40% vested.
40% of the employer’s contribution of$2,000 ($2,000 x 40%) is $800.
Account Balance After Terminating Employment: $6,800*
*The account balances in these examples exclude any earnings or losses from investment.
When the employee leaves the company, he or she can leave the funds in the 401k or roll them over into another retirement savings account such as an IRA or a Simple IRA.
401k is a Great Way to Save For Retirement
Regardless of the vesting period set by an employer, any company match into an employee’s 401k is a huge benefit. Even in the cases where employers do not match contributions, 401ks have significant benefits. Contributions made into the retirement account are taken directly out of an employee’s paycheck pre-tax. Those funds then continue to earn a rate of return and those earnings also grow tax-deferred. Obviously, at the normal retirement age per the IRS, there will be taxes due when the employee becomes a retiree and starts withdrawing money from his retirement account. Ideally, his tax bracket is low due to earned income being lower during retirement.
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