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What Is Vesting?

Having employee benefits is one of the best ways to work toward your retirement. Options like employee-sponsored 401(k)s and stock options, like vesting, can help you reach your financial goals.

Companies that offer employees a “vested interest” or stock option in their company have found a way to ensure loyalty and long-term security for their employees. So what is it? The term “vesting” itself is the process where an employee earns the right to employee stock options or other compensation benefits.

In other words, if your employer offers you equity as part of your compensation package, your stock will need to vest first before you become an owner.

How Does Vesting Work?

As an employee, each individual will own (or vest) a percentage of their retirement plan, other benefit plan, or stock-option. Once an employee reaches 100% vested in their account, they own the full balance.

This means that the employer cannot take any portion back for any reason at that point. However, if an employee has no vesting or is only partially vested, they will forfeit some or all of the contributions when the balance of the account is paid out.

It’s important to differentiate between the amount you contribute yourself and the amount your employer contributes on your behalf. Any money that you contribute yourself does not apply to vesting.

It is your money to keep regardless of how long you work for that company or if you choose to find employment elsewhere. Vesting only applies to the funds that an employer contributes.

What Is an Example of Vesting?

In this example, Jane Doe works for Employer A. Employer A matches employee contributions that Jane makes to her retirement plan, and they vest over a three-year period.

Over the course of the three years, the employer contributes this free money to Jane’s retirement account. But the free money does not become Jane’s until she fully completes three years of employment, also known in this case as the vesting period.

What Is Stock Vesting?

Stock vesting is another employer benefit that some companies offer. Companies can offer three main types of stock options: incentive stock options (ISOs), non-qualified stock options (NSOs), and/or restricted stock units (RSUs).

Incentive Stock Options (ISOs)

Incentive stock options qualify for special tax treatment. While you are not getting shares of the stock initially, you instead get the right to buy a set number of shares at a fixed price in the future.

Unlike the other options, you typically won’t have to pay taxes when you decide to exercise (buy) ISOs. Additionally, you may qualify for lower tax rates if you meet certain criteria.

With ISOs you usually cannot buy all the shares right away and are required to work for the company over time to be able to be fully vested.

Non-Qualified Stock Options (NSOs)

Similar to ISOs, NSOs are also stock options that some employers provide as part of their compensation package. But this type of stock option does not typically have favorable tax treatment.

You pay taxes when you exercise (buy) the option and when you sell the shares with NSOs.

Restricted Stock Units (RSUs)

Unlike the stock options above, an employee does not have to purchase the RSUs. Instead, the company is just giving you stock at no cost to you, at some point in the future.

The company will have a set milestone you must reach before you are vested.

What Are Vesting Periods?

This is the designated time that an employee must work for an employer to 100% own the contributions, company stock, or stock options.

How Long Is a Vesting Period?

There are different types of vesting periods, each with their own requirements. The most common is three to five years.

However, this does not apply to all employers. Some employers may have a zero or immediate vesting period (the employee will own any shares or contributions immediately).

Other vesting periods can last up to ten years.

Types of Vesting Periods

The type of vesting period is up to the discretion of the employer. Each will utilize one of the following types of periods: cliff, graded, or intermediate vesting periods.

Cliff Vesting

Cliff vesting is the process that entitles an employee to their full benefits on a given date. For example, if a company has a two-year cliff vesting schedule, an employee will be 100% vested after 2 years of employment.

If they quit or their employment is terminated before the two-year employment anniversary, they are not entitled to the benefits because your period was incomplete. From day one to day 729 they are 0% vested.

Graded Vesting

Graded vesting is the vesting process that over time, the employee gains ownership of employer contributions. The plan’s schedule will determine the percentage vested and how much of the contributions you are entitled to.

For example, if a company has a 4-year graded vesting schedule, from the date of your hire to your first year of employment you will be 0% vested. After your first year of employment, you will be 25% vested.

Once the second year of employment is completed, you will be 50% vested. After your third year of employment, you will be 75% vested. Then after your fourth year of employment, you will be fully vested.

Immediate Vesting

Immediate vesting is the most straightforward. An employee immediately owns the benefits upon their first day of employment.

Even if an employee were to leave after the first month, they would take 100% of their contributions/benefits.

Why Do Companies Need Vesting?

The reason that many employers have vesting policies is to encourage their employees to stay with their company. It provides employers with less turnover as many employees will stick with their positions until they are fully vested to get the most out of their benefits.

It is also an important feature for hiring managers when they provide compensation packages for employees they are trying to recruit. An attractive benefit plan is a great way to find quality employees.

Why Is Vesting Important?

It is important because it rewards those who work to make a company great, and keeps all parties committed to the success of the company. Vesting schedules also protect the employer from losing money on benefits for employees that do not stick around for the long haul.

Are You Fully Vested?

While you should not make career decisions based solely on vesting, it is an important detail to consider if you are looking for employment. Finding an employer that is willing to invest in your financial future can be beneficial for both parties.

If you are currently employed and unsure if you are fully vested, reach out to your human resources department to provide additional information about your benefits.