On your first day of work you’ll probably be greeted with a big stack of documents that will cover everything from your health insurance options to paid time off to even the mechanics of getting your paycheck deposited in your bank account.
And if you’re lucky enough you’ll also be getting a document explaining compensation beyond your salary or typical benefits, like investment vehicles such as stock, profit sharing, or retirement savings.
For benefits that might include an employer contribution, there is typically a vesting time, after which the employee owns — is vested in — the amount the employer contributed to the plan. An employee is always 100% vested in the amount they contributed to their own retirement plan.
When the full amount of the employer contribution is received all at once, that is what is known as “cliff vesting.”
Related: How to roll over your 401(k)
Cliff investing in retirement plans
Qualified defined contribution plans like 401(k)s typically allow employees to contribute pre-tax income to a retirement investment plan. Some employers also contribute to the plans. At what point the employee is vested in those employer contributions depends on the type of vesting schedule the employer chooses: cliff or graded.
Cliff vesting is, as described above, when the employee receives the employer contributions at one time. Graded vesting is when the employer contributions are vested in percentages over several years.
One standard graded vesting schedule, according to the IRS, is 20% after two years of employment, 40% at three years, 60% at four years, 80% at five years and then full 100% vesting after six years of employment.
Cliff vesting in retirement plans is subject to IRS regulations, which differ depending on the type of company offering the plan.
Employer contributions to SEP and SIMPLE IRA plans are always 100% vested by the employee. For other qualified defined contribution plans (e.g., profit sharing or 401(k) plans), the IRS allows employers to determine the vesting schedule.
For instance, one company may vest contributions after one year of service, but another company may not until after three years of service. The only firm timeline the IRS states is that employees must be 100% vested by the time they reach normal retirement age or the plan is terminated.
Restricted stock as an employee benefit
Some companies may offer employees the option to purchase company stock as part of the benefits package. Restricted stock units are subject to vesting schedules similar to those of retirement plans.
Employees may be granted shares of the company stock on a certain date — the grant date — but they do not own those shares until they are vested in them. Like retirement plans, the vesting schedule is set by the employer.
With graded vesting, restricted stock or options are doled out over a four-year period, and the employee might be vested in 20% or 25% of the stock granted after their first 12 months of employment, with the rest of the stock vesting in similar increments.
This is to ensure that employees stick around for at least a year and the company doesn’t get diluted by handing out stock to a carousel of employees who won’t stay at least that long.
Cliff vesting works a little differently, though. An employee who has a restricted stock grant of 10,000 shares will not actually receive any of it until an employer-determined work anniversary, perhaps after one or two years of employment.
These schedules are important to pay attention to if you’re planning on selling your employee stock before you get all of it or after.
Another form of vesting reminiscent of cliff vesting is “milestone vesting,” where an employee’s options or shares are earned not based on time of service according to a preset schedule, but instead on specific personal or corporate goals
Prospective employees would be wise to have a clear understanding of what these milestones are, and how and when they can be achieved.
Because the opportunity to earn restricted stock can be a compelling reason to work at a growing company, any misunderstanding that might arise can be devastating and could lead to ill will and early employee departures.
Alternatively, if the milestones are clearly outlined with no room for misinterpretation, the employee potentially has much to gain.
A young company might offer milestone vesting in restricted stock because there may be an opportunity for company growth over time, making stock an attractive form of compensation to employees. A young company may also have more immediate ability to distribute stock than to distribute cash.
Deciding if the cliff is worth the risk
Cliff vesting can be seen as either a risk — you may never get any of the shares if you leave the company before your vesting date — or as a way for employers to encourage their employees to stay until a certain date.
If an employee leaves a company before their vesting milestone hits, they could be out of stock or retirement plan employer contributions that they may have counted on receiving. Another risk employees may face is losing those contributions if there is a company buy-out or the company puts new policies into place, superseding the old ones.
Shares or options can align employer and employee, an incentive for the employee to feel like they aren’t just working for a salary, but to make the company more valuable in the long run. They will have a vested interest (pun intended!) in the company.
Employees who have the option to receive stock as a benefit may want to keep tabs on how that stock is performing. Talking with a financial planner may also be a big help in making a decision about whether to take the stock option.
Determining if the stock fits into an investor’s goals is a big part of what a financial planner does. They can help an investor determine the best way to invest smartly and reach their goals.
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