If you are just starting a 401(k) at your company, you may be wondering about vesting. How should you decide what type of vesting schedule to establish? Does it really matter? Although some people might not think so, we think it matters, and the schedule you settle on can affect many aspects of your business. In this post, we explain how your choices matter to your business today, and in the future.
What Is Vesting?
Even if you never heard of vesting as it relates to a 401(k), you likely heard of a vested interest. For example, if you are a worker at a company, you may have a vested interest in whether your company wins a particular contract, because that could mean continued work and more money for you. It’s similar to investment, meaning you have put your time, effort, or money into a situation that you hope pays off.
Vesting, as it relates to 401(k)s, refers to an employee’s entitlement to the funds in their 401(k). However, vesting only applies to company match funds; employees’ own contributions are always 100% theirs. The ones you make on their behalf become their property only under conditions that you as the employer are allowed to set.
Employer Contributions to 401(k)s
While employer contributions to 401(k)s are definitely looked upon favorably, they are by no means required. This means you can sponsor a 401(k) plan at your company for your employees but never make any contributions on their behalf. This isn’t quite as bad as it sounds. Sponsoring a 401(k) plan for your employees means they have access to a 401(k) that they otherwise would not have. While anyone can open an IRA as a means to start saving for retirement, this vehicle isn’t nearly as good as a 401(k), even a 401(k) with no company match. That’s because the maximum a worker can contribute to an IRA is $7,000, while the maximum they can contribute to a 401(k) is $23,000 (in 2024). This is a huge difference. A 401(k) can net an investor hundreds of thousands or even millions more during their lifetime than an IRA can.
Unfortunately, the only way a worker in the U.S. can get access to a 401(k) is through an employer. With almost all businesses in the U.S. being small businesses, problems arise when these companies can’t (or won’t) offer employees 401(k) plans. And the smaller the business, the more likely a company is not to offer a 401(k). Historically, the reason has been that starting a 401(k) is too expensive, and keeping it running is too laborious. 401GO’s mission is to provide small businesses with the opportunity to offer a 401(k) plan to employees at a minimal cost and with setup that takes only minutes instead of weeks.
The U.S. government has taken notice of the fact that many small businesses don’t offer 401(k)s, and in many states, providing access and automatic contributions to an IRA is mandatory. This is very nice, but you already know now what the limits of an IRA are.
Thus, the bottom line here is that you aren’t required to offer a match when you start a 401(k) at your company, and if you don’t, you will still be offering your employees a valuable benefit. But it won’t be as valuable as businesses that do offer a match.
Matching Contributions
When employers offer a match for employees’ 401(k) contributions, it’s often 50% up to 6%. That being said, you are in no way tied to this formula and can match any percentage you choose. It’s probably best not to make it too complicated, however, because you want employees to easily understand the benefit they get by working at your company.
For example, an employee earning $100,000 and putting 6% of their salary in their 401(k) at a company with a 50% match actually gets $103,000. If they contribute less than 6%, they are, in effect, foregoing free money from their employer. If that same employee works for a company that does not offer an employer match, they are effectively getting less compensation each year.
Vesting Schedules
For the most part, both employees and employers know how valuable an employer match is, and that’s why some employers create a vesting schedule. These employers use the vesting schedule as leverage to keep employees tethered to the company longer and discourage them from leaving to take a better offer.
There are two main types of vesting: cliff and gradual. With cliff vesting, the matching funds become employee property all at once on a specified date in the future, while with gradual vesting, the employee gets a larger percentage at certain preset intervals.
Commonly, vesting schedules are between three and five years. If we use the same example above of the employee who earns $100,000 and puts 6% of their salary in their 401(k) and gets a 50% employer match, in three years the employer will have contributed $9,000 to the employee’s account, and in five years $15,000.
Some employers choose to set a vesting schedule so that if the employee leaves the company before a certain time period, they forfeit the employer matching funds.
Vesting: Yea or Nay?
We titled this blog “How to Establish a Vesting Schedule for Your Company’s 401(k),” but it’s less about the percentages and more about what you should consider when you are thinking about a vesting schedule.
Simply having a vesting schedule, while not uncommon, presents the potential to be viewed by employees as adversarial. It’s a way to encourage them into staying at your company when they might otherwise choose to leave, and it can lead to hard feelings. You can find all kinds of statistics online about how many companies have vesting schedules and how many don’t, but we can say it’s roughly about half and half.
Factors you may want to consider before deciding whether to establish a vesting schedule include:
- Whether your competitors have vesting schedules
- How long your employees typically stay at your company
- Whether your company culture is generally friendly and welcoming, or more strict and authoritarian
If none of your competitors has a vesting schedule and you do, it could make you look cheap, apprehensive or mistrustful. If you have high employee turnover, a vesting schedule could look like a way to make it easier to mistreat employees. If you run your business like it’s a family and you introduce a vesting schedule, you run the risk of alienating the loyal employees you already have. On the other hand, if you make it clear that the employee-employer relationship is strictly business, you may have fewer issues with introducing a vesting schedule.
Whatever you choose, know that if it doesn’t seem to be working out for you, you can try changing it down the road to see if things improve. Just make sure to give each way enough time to see how it works for your company.
