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

A 401(k) vesting schedule is used by employers to control when ownership of retirement contributions transfer to employees. While many 401(k)s vest contributions immediately and no schedule is needed, there are two other types of schedules, cliff and graded, that employers can use to vest retirement contributions over time or all at once.

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How a 401(k) Vesting Schedule Works

When employees make retirement account contributions, those contributions always vest immediately. However, employers who provide matching or profit-sharing have the option of using a schedule to vest employer contributions over time. Using a 401(k) vesting schedule penalizes employees who leave a company early, because they forfeit some or all employer contributions to their account.

A vesting schedule does not impact employee contributions in any way, nor does it affect the schedule for employer matching or profit-sharing. Employers are still required to follow the guidelines outlined in plan documents. That means that:

• Graded and cliff schedules don’t save employers money upfront.
• Employers must make the same monthly/annual contributions whether vesting is immediate or on a graded/cliff schedule.

However, if an employee leaves early and their employer has a 401(k) vesting schedule in place, the employee may forfeit some of their employer contributions by leaving early. This means that:

• If an employee leaves early, they do not get to take any unvested employer contributions with them.
• They will get to keep all of their employee contributions, which are always 100 percent vested.
• Any unvested employer contributions will stay in the plan.
• Employers leave that money in the plan and can use it to pay plan expenses, add to employer contributions, or cover future employer contributions.
• In some cases of terminated plans, employers can take unvested funds out of the plan, but those withdrawals may be subject to a 50 percent tax.

There are minimum requirements for cliff vesting schedules and graded vesting schedules discussed further in the 401(k) Vesting Schedules: Cliff vs. Graded section below. However, employers who want to provide employees with vested retirement contributions sooner aren’t prohibited from vesting contributions faster.

The three main vesting options that employers can use for employer contributions include:

Immediate Vesting

Immediate vesting is required for certain retirement plans, including SIMPLE IRAs, SEP IRAs, and Safe Harbor 401(k)s. With immediate vesting, employees get ownership of employer contributions to their retirement account without any delay. If an employee leaves the day after employer contributions are made, they still get to keep 100 percent.

When to Use Immediate Vesting

Immediate vesting is sometimes required and may be the best option in some cases, including:

• Businesses that need to compete for top talent – Businesses that recruit highly-trained engineers or other employees can get an advantage in attracting talented employees if they offer immediate vesting.
• Low plan participation – If you don’t have many employees contribute to a retirement plan or they only make minimal contributions, the time required to use a 401(k) vesting schedule may not be worthwhile.

Graded Vesting Schedule

In a retirement plan with graded vesting, employer contributions to employee retirement accounts become vested gradually over time. According to the IRS 401(k) vesting rules, a graded vesting schedule requires employers to vest retirement contributions (for contributions made after January 1, 2007) with no longer than a “two- to six”-year graded vesting schedule.

In a “two- to six”-year graded vesting schedule, employers vest retirement contributions to employee accounts gradually, with 20 percent being vested in year two and an additional 20 percent vested each year thereafter until they’re fully vested in year six. Once an employee reaches six years of service, they are fully vested for all previous, current, and future employer contributions. Vesting doesn’t reset for each employer contribution.

A “two- to six”-year vested grading schedule vests employer contributions after each year including:

• Year 1: 0%
• Year 2: 20%
• Year 3: 40%
• Year 4: 60%
• Year 5: 80%
• Year 6: 100%
• Year 7+: 100%

When to Use a Graded Vesting Schedule

A graded vesting schedule can be beneficial in some cases, including:

• Traditional industries – Areas like manufacturing that want to reward employee loyalty.
• Companies that have employee turnover in years three to five – These business owners could save a lot of money with a graded vesting schedule over a cliff schedule.

Cliff Vesting Schedule

In a cliff vesting schedule, employees get vested retirement contributions all at once rather than gradually. 401(k) vesting rules limit the amount of time that employers can delay vesting under a cliff vesting schedule to three years. That means that all employer contributions must be fully vested with employees no later than three years.

A cliff vesting schedule is a way that employers can simplify their vesting. Rather than vesting contributions a little at a time, contributions vest all at once. In a 401(k) that uses a two-year cliff vesting schedule, for example, once an employee has  completed their second year of service, they are fully vested in all employer contributions made in their account up to that point and afterward.

A two-year cliff vesting schedule vests employer contributions all at the end of the same year:

• Year 1: 0%
• Year 2: 100%
• Year 3+: 100%

When to Use a Cliff Vesting Schedule

A cliff vesting schedule is the best fit for certain business situations, including:

• Start-ups – New companies that are looking to scale quickly.
• New divisions – No areas of a business that may be shut down if it doesn’t turn a profit quickly.
• Boom-or-bust businesses – Businesses that see profits fluctuate wildly and high employee turnover.

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Only certain kinds of retirement plans are allowed to use vesting schedules. You can’t use vesting schedules in SIMPLE IRAs, SEP IRAs, or Safe Harbor 401(k)s for example—all employer contributions must be vested immediately. If, however, you have a 401(k) plan and want to guard against high employee turnover, then you may want to consider using a cliff or graded vesting schedule.

“If you can point to a specific time frame where employee turnover significantly decreases, after which your employees are more than likely to stay with the company for a long period of time, then a cliff requires the employee to stay for a certain amount of time and greatly rewards them once they hit that threshold. Graded vesting requires employees to have to stay for a longer period of time to get the full vest. Employees have to stay for the entire vesting period before getting 100 percent. – Nick Ferdon, Sales Manager, Human Interest

401(k) Vesting Schedules: Cliff vs. Graded

While employers using cliff or graded vesting schedules can delay employee vesting from three to six years (depending on which schedule they choose), most employers use shorter vesting schedules in order to attract talented employees to their company. Most employers using cliff vesting schedules, for instance, use a one- or two-year cliff. For graded vesting schedules, one- to five-year graded vesting is common.

Employers who want to be even more generous, however, can simply use immediate vesting or make sure that employees have fully vested retirement plans within one to two years. This system penalizes employees who leave the company in less than 12 to 24 months while rewarding employees who have put in one to two years of service with the employer.

401(k) Vesting Schedule Examples

A 401(k) vesting schedule is a good tool for employers with highly-paid employees and frequent employee turnover—especially in industries like technology. Using a 401(k) vesting schedule creates a golden handcuff binding employees to the company. Employees are effectively penalized for leaving so they have an incentive to stay with the company longer.

For example, let’s consider an employee, John Smith, who earns $100,000 per year and contributes three percent—$3,000 per year—to his retirement account. Let’s also assume that his employer matches 100 percent of employee contributions up to three percent or higher. For purposes of this example, we’ll assume that John’s employer has no profit-sharing.

If John left after two years of service, his 401(k) vesting schedule would impact the portion of employer contributions he’d get to keep. Here’s how John would be impacted based on different types of vesting:

Immediate Vesting Example

If John’s employer used a Safe Harbor 401(k), SIMPLE IRA, or SEP IRA, then any employer contributions to John’s retirement account would be vested immediately. It wouldn’t matter whether John left in his first year, his fourth, or his fortieth—he would get to keep any contributions made by his employer into his retirement account.

Cliff Vesting Schedule Example

If John’s employer used a three-year cliff vesting schedule—the longest allowed by the IRS—then in our example John wouldn’t get to keep any employer contributions to his retirement account. If he had stayed for an extra year—until the end of his third year of service, then he would’ve been able to keep 100 percent.

Graded Vesting Schedule Example

If, on the other hand, John’s employer used a two- to six-year graded vesting schedule—the longest graded vesting allowed by the IRS—then John would keep 20 percent of employer contributions to his retirement account if he left after his second year of service. If John stayed another year and left after three, he’d keep 40 percent.

401(k) Vesting Schedule Costs

The biggest difference between graded and cliff vesting schedules is the difference in cost. The difference is not in administrative costs, which are essentially the same, but in the portion of employer contributions that employees can take with them if they leave within the first two to six years of employment.

Cliff Vesting Schedule Costs

A cliff vesting schedule allows employers to wait longer before vesting retirement contributions, but employees become fully vested more quickly. Under a three-year cliff vesting schedule, employees who leave before completing three years of service wouldn’t keep any employer contributions to their retirement account. However, employees leaving after their third year would keep 100 percent of employer contributions.

Graded Vesting Schedule Costs

Graded vesting schedules spread vesting of employer contributions over time. However, graded vesting schedules also allow employers to delay 100 percent vesting longer than cliff vesting. An employee leaving after their third year of service with a two- to six-year graded vesting schedule, for example, would get to keep 40 percent of employer contributions to their retirement account.

401(k) Vesting Rules

In order to use a 401(k) vesting schedule, employers must adhere to certain 401(k) vesting rules. Employers must make sure that they have a retirement plan that is eligible for vesting. Employers must ensure that their vesting schedule applies to all eligible employees based on hours worked per year. Vesting schedules also need to be specifically spelled out in the plan.

Four 401(k) vesting rules include:

• Apply to eligible employees – The vesting schedule must apply evenly to all employees and owners who work enough hours to qualify for the plan.
• Include vesting schedule in plan documents – Employers who elect to use a 401(k) vesting schedule must spell out the details of plan vesting in their plan documents.
• Strictly adhere to plan documents – Employers must strictly follow the vesting schedule as outlined in their plan’s governing documents.
• Disclosed to employees – All employees eligible to participate in the plan need to be made aware of the vesting schedule as soon as it is implemented (or as soon as they become eligible).

401(k) Vesting Schedule Pros & Cons

There are many advantages and drawbacks to using different 401(k) vesting schedules. While a cliff vesting schedule is simpler and easier to administer, it also requires that employees be fully vested sooner than in a graded vesting schedule. Graded vesting, on the other hand, allows employers to delay 100 percent vesting for longer but may breed resentment among employees.

Pros of Using a Vesting Schedule

The pros of using a vesting schedule include:

• Can reduce high employee turnover
• Company gets back unvested contributions for employees who leave early
• Gives employees a vested interest in the long-term success of the company

Cons of Using a Vesting Schedule

The cons of using a 401(k) vesting schedule include:

• Require additional administration and testing
• Can deter potential employees who have the option of immediate vesting with a different employer
• More opportunities to violate 401(k) vesting rules

Pros of Cliff Vesting Schedule

The pros of using a cliff vesting schedule include:

• • Employee doesn’t have to be vested immediately
  • Easier than graded vesting to track and administer

• Employees aren’t entitled to keep any employer contributions until they’re fully vested
• Better for start-ups or new lines of business that may not survive

Cons of Cliff Vesting Schedule

Some cons of a cliff vesting schedule include:

• Employees must be fully vested sooner
• No partial vesting for employees who leave just before or just after their vesting date
• Not available in some plans, including SEP or SIMPLE IRAs
• Employers get nothing back if employee leaves in years four to five
• Bad for more traditional industries that have high turnover in years three to four

Pros of Graded Vesting Schedule

There are pros of a graded vesting schedule, including:

• Employees don’t have to get any vesting right away
• Vesting occurs a little at a time
• Employers can delay longer—up to six years—before employees are fully vested
• Employer better guarded against employees leaving in years three to five than in a cliff vesting schedule
• Good for traditional industries that aren’t sink-or-swim

Cons of Graded Vesting Schedule

Some of the cons of a graded vesting schedule include:

• More confusion on individual employee vesting level
• Employee resentment for longer vesting period
• Potential for mix-ups if you change plan providers
• Made for industries that have to compete for talent

Frequently Asked Questions (FAQs)

What Is a Vesting Period?

A vesting period is the number of years of service that an employee must work before their employer’s contributions are fully vested in their retirement account.

Are Contributions from Different Years Vested Separately?

No. Vesting in a retirement plan is cumulative—once an employee completes their vesting period, they are fully vested in all employer contributions to their retirement plan in the past, present, or future.

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

A 401(k) vesting schedule is not available in certain employer-sponsored retirement plans, including SEP IRAs, SIMPLE IRAs, Safe Harbor 401(k)s, and Solo 401(k)s.

Can a Plan Change to Immediate Vesting?

Yes. A 401(k) plan can always amend their plan documents to change their vesting schedule—including to move to immediate vesting—as long as they meet minimum vesting standards.

What Does It Mean to be 100% Vested?

Once an employee is fully vested in their retirement plan, they are entitled to 100 percent of any employer contributions made in their account. If an employee leaves before becoming fully vested, they may not be allowed to keep all or—in some cases—any of the contributions their employer has made to their retirement up to that point.

Bottom Line

Immediate vesting can penalize employers who invest substantial time and money in new employees who leave within one to three years. If you’re in an industry with highly-compensated employees or have high employee turnover, a 401(k) vesting schedule for retirement benefits can help you retain employees by creating a disincentive for employees to leave before they’re fully vested.

The experts at ShareBuilder 401k will help you identify the best type of 401(k) plan to offer your employees. Whether it’s immediate, graded, or cliff vesting schedules, their advisors will help you determine the right plan design, conduct employee education, and answer all your 401(k) questions.

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