Vesting: What is it and how does it work?

Vesting is a legal term that refers to a point after a specific time period, known as a vesting period, at which a person acquires legal ownership of some kind of property. The person then has a “vested right” to that asset. Nobody can take it away from them, even if they don’t yet have the asset in their tangible possession.

What is vesting?

As a business owner or human resources manager, you may come across the term vesting in one of two scenarios: employee retirement planning or employee equity. What is vesting in these contexts?

To understand vesting, you first have to answer the question: What is a vesting schedule or a vesting period? A vesting schedule or vesting period refers to the time an employee must work for a company before they are permitted to own equity-like employee stock options or company shares—or able to access employer contributions to a retirement plan, like a 401(k).

Vesting periods vary depending on the type of asset. The U.S. government has regulations limiting a vesting period’s potential duration for retirement plans. The vesting period is usually negotiated in the initial contract between the employer and employee for stock options or shares.

What is 401(k) vesting?

A 401(k) is a type of tax-advantaged retirement plan that’s company sponsored. U.S. employers may offer their employees this plan. Employees who opt to sign up for a 401(k) agree to have a portion of every paycheck they receive deposited into an investment account. Depending on the terms, the employer may match part or all of the employee’s contribution.

When discussing retirement plan benefits, the vesting schedule determines when the employee fully owns the retirement assets, giving them nonforfeitable rights. The balance generally depends on time. While the amount deducted from the employee’s paycheck is theirs no matter what—they retain the rights to that money—they don't get immediate rights to the employer-matched amount.

The money from the employer must vest before it becomes the employee’s. Once the vesting period (typically three to four years) concludes, the employee is what’s known as “fully vested.” They then have full rights to their contributions and the employer’s contributions.

What is a vested balance in 401(k)?

The amount of money an employee currently owns in their 401(k) is known as their “vested balance.” If they leave their job or want to withdraw money from their retirement fund, the vested balance tells them what they’ll have access to.

What happens to 401(k) money that is not vested?

Employees should be able to answer two primary questions when considering a vested 401(k): What is the vesting period, and what is a vested balance? Why is this so critical? Employees have no rights to money that isn’t vested. That means employer contributions may be lost, either fully or in part. This is basically like throwing away free money.

What is stock vesting?

Vesting schedules can also be applied to employee stock options or company shares. Employees who get non-qualified or incentive stock options on a vesting schedule don’t get those assets immediately. Instead, they’re given the right to exercise stock options. In other words, they can buy a certain number of shares at a fixed price in the future.

There is also the option of giving employees restricted stock units. In this case, they get actual shares of stock, which they’re permitted to sell later. A vesting schedule applies, so employees must stay at the company for a certain period.

Regarding equity, vesting schedules can be time-based or milestone-based. For example, in a time-based arrangement, employees must stay with the company for a set amount of time before their options or shares are fully vested. What is the vesting period? It depends. Many companies opt for a one-year cliff—so a chunk of the shares or options vest after one year, and then the rest gradually vest over time.

Milestone-based vesting means that employees get their options or shares when specific milestones are met, such as completing a project or reaching a set objective. Another example could be if the company achieves an initial public offering, or IPO. Milestone-based vesting is less common than time-based vesting.

What’s the reason for vesting?

What are vesting schedules, and why would companies institute them? Companies tend to introduce vesting periods to reduce turnover, which helps employers save on recruitment and training costs. With vesting schedules, companies can confidently offer their employees perks like retirement matching and equity without worrying about losing money on an employee who doesn’t stick around.