Defined benefit plans and cash balance plans are complex. One question that business owners often ask: what does employee vesting mean and how does is apply to my business?
Retirement plans will generally require contributions for all eligible employees. However, there are ways to improve the plan economics for the owner. This can be accomplished by adding vesting restrictions.
In this post, we will discuss how vesting is applied to employees. We even have an example so you can see how vesting is applied at the individual employee level. Let’s dive in.
Table of contents
What is Employee Vesting?
What does vesting mean? Essentially, it means ownership.
Even though an employee may have received an allocation under a defined benefit plan or cash balance plan, they don’t have a right to the funds until they actually vest.
Some plans are structured with immediate vesting. In this case, the employee has immediate ownership in the funds when contributed. If they leave the company they get to take the funds with them.
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But the IRS allows plans to have up to three year vesting. They also allow graded vesting or cliff vesting (more about this later).
How Does Employee Vesting Work?
So let’s discuss the vesting for each of the employees. First of all, vesting is all or nothing. The employee is either vested in their entire balance or none at all.
Some people assume that employees will vest separately in each year and for each contribution. This is simply not the case. Employee vesting is not applied annually based on a specific allocation.
Once an employee meets the vesting date, they are vested for the entire amount and all future contributions and interest credits.
Vesting does work independent of contributions in one situation. If an employee was hired during a plan year they can normally be excluded from receiving a contribution for the year.
However, for vesting purposes, as long as they worked at least 1,000 hours in the year they would accrue a year of vesting starting on January 1st of that year.
So if an employee was hired on July 1st of a given year and will not enter the plan until January 1st of the following, they will still receive one year of vesting. This is one subtle difference.
Regardless of the vesting schedule provided in the plan document, all employees who reach retirement age (usually 62 or 65) are required to be 100% vested.
Also, please realize that an employee does not have to be employed on the last day of the year (or computation period) in order to receive to receive a vesting credit for the year. The participant only needs to work at least 1,000 hours to be credited for the year of service.
What Are the Vesting Date Options?
I understand that vesting begins and ends with a specific date. How are these dates determined? When does the three year vesting period start?
Your plan document will specify the plan vesting dates that are used. There are basically two different measurement dates.
Date of hire. The start of the vesting period begins when the employee was hired. The date the plan was established is irrelevant. For example, the plan could be implemented during 2021. However, if all the employees were hired in 2015 you can use their respective hire date in 2015 to start the vesting period (they are all of course vested).
Plan year. This is the most common option. The vesting is determined based on the plan year. For example, if a plan is set up in 2021 and all the employees were hired in 2015 then the beginning vesting date for measurement will be 1/1/21. All the years of service before the plan was implemented are excluded.
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The plan year option will of course make the most sense for most companies. This is because you don’t want to set up a plan in a give year and have to vest all employees who have been with you long before the plan was set up.
Cliff Vesting Vs. Graded Vesting
There are three vesting schedules that you can adopt. Each can have pros and cons. However, the most common is called “cliff” vesting. Let’s discuss the options.
Immediate vesting based on the contribution date. This one is straightforward. Employees are fully vested in employer contributions once they receive a contribution.
Graded vesting. This vesting schedule is more often used for profit sharing plans. Employees earn ownership gradually as they continue to work at the company. For example, they might earn 20% a year until the employee is 100% vested. If the employee terminates before being fully vested, he or she can only keep the percentage of funds in which they were vested. The IRS allows up to six-year graded vesting maximum.
Cliff vesting. This vesting schedule gives the employee 100% ownership at a certain date in the future. It is all or nothing. The vesting date can be from one year to three years. If the employee terminates before this date, he or she receives nothing. The IRS allows a maximum cliff vesting of three years.
What happens if an employee does not vest?
Any unvested allocations are forfeited back into the plan and will be used to reduce future contributions. The company still gets the tax deduction from the initial contribution.
Employee Vesting Example
We know that vesting questions can be somewhat complex, so let’s look at an example. Let’s assume a company set up a defined benefit plan with the following provisions:
- Plan for calendar year 2021 (effective date of 1/1/21)
- Five full time employees (excluding owner)
- Normal retirement age of 62 and semi-annual entry dates
- 3 year cliff vesting
- Vesting based on plan year and NOT hire date
- Benefit crediting and eligibility based on counting hours method
- 1 year of vesting awarded if 1,000 hours worked during year
We are going to spell out the relevant employee information in the table below.
| Name | Birth Date | Start Date | Term Date | Date Vested | |
|---|---|---|---|---|---|
| Adam | 01/19/00 | 04/17/15 | N/A | 12/31/23 | |
| Bella | 11/28/77 | 10/08/20 | N/A | 12/31/23 | |
| Cara | 08/11/92 | 03/22/21 | 11/03/23 | 11/03/23 | |
| Dave | 03/12/85 | 08/15/14 | 10/26/22 | N/A | |
| Ellie | 05/09/50 | 7/28/19 | N/A | ||
So let’s take a look at how and why each employee is vesting. Along the way, we will examine a few key distinctions.
Adam
This situation is rather common. Adam is not of retirement age and started working at the company five year before the plan was established. He is still employed by the company. Since the plan vesting date will begin on 1/1/21, Adam will be fully vested on 12/31/23. This is straightforward.
Bella
Again, Bella’s situation is rather straightforward. Her vested date will the same as Adam’s even though she was hired five years after him. Remember that all that matters is the effective date of the plan. It does not matter when the person’s employment began.
Cara
Cara’s situation gets a little more interesting. Why is her vesting date before Adam and Bella considering she left the company?
The answer lies in the number of hours worked each year. Remember that these are full time employees, so Cara would have worked over 1,000 hours for years 2021 through 2023.
But you may be asking why Cara gets a year of vesting for 2021 even though the company will not be making a contribution for her for the year.
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Herein lies the measurement differences for contribution years and vesting years. For contribution purposes, Cara would not have been eligible to receive a contribution for 2021 because she would have been eligible for plan entrance on 1/1/22 (she started working in the year the plan was established.
However, since Cara worked 1,000 hours during 2021 she still will be credited for a year of service even though she will not receive a contribution for year. This is an important distinction and should not go unnoticed.
Dave
Dave worked over 1,000 hours for both 2021 and 2022. So he earned two years of vesting service. However, since he left the company in late 2022 he earned less than the three year vesting. As such, his entire defined benefit plan balance (both pay credits and interest credits) is forfeited.
Ellie
Ellie’s situation is unique and should not be overlooked. Since she is over the age of 62 (the plans designated retirement date) she is fully vested in all plan contributions and the three year vesting period does not matter.
We know that older employee will require larger contributions. However, immediate vesting in situations like this can be very challenging for the plan economics and are often overlooked.
Final Thoughts
With a typical plan structure, the goal is to get at least 90% of the plan contributions allocated to the owner. This can be improved when you consider vesting options.
