Vesting is like a payday for your 401(k) account, since it gives you access to additional money in the form of employer contributions to your account. Many employers make these contributions to employee 401(k) accounts as a perk of employment. However, until you are vested in these amounts, you don't legally own them. Just like your own tax-deductible contributions, employer contributions also grow tax-deferred in a 401(k) account.
TL;DR (Too Long; Didn't Read)
When you're 20 percent vested in your 401(k), that means you're entitled to ownership of 20 percent of the contributions your employer has made.
Definition of 20 Percent Vested
While you're always vested in your own 401(k) contributions, you're usually not vested in employer contributions for a number of years. Your employer must provide you with a vesting schedule that shows you how long it takes for your employer contributions to vest. If the vesting schedule shows that you are "20 percent vested," it means that 20 percent of your employer's contributions are now irrevocably yours. If you choose to withdraw your 401(k) money or roll over your 401(k) into another plan, you can take 20 percent of your employer's contribution with you.
Understanding Graduated Vesting
Graduated vesting is one of the two types of vesting schedules for retirement plans allowed by the U.S. Department of Labor. Under a graduated vesting schedule, you "vest" or own an increasing percentage of your employer's contributions depending on your length of service. The Labor Department requires that employees vest at least 20 percent after three years and an additional 20 percent for each subsequent year.
For example, if you have been with your employer for four years you must be at least 60 percent vested in your employer contributions. If you are 20 percent vested in your 401(k), your employer uses graduated vesting.
Exploring Cliff Vesting
If your employer doesn't use graduated vesting, it must use cliff vesting. Under cliff vesting, if you have been with your employer for less than three years, you are zero percent vested. As soon as you have been with your employer for three years or more, you become 100 percent vested. You cannot be 20 percent vested under a cliff vesting program.
Considering Withdrawal Limitations
Just because you are vested in 20 percent of your 401(k) doesn't mean you can withdraw that amount free and clear. While being vested means that you own that money, it doesn't affect IRS rules regarding 401(k) taxes and penalties.
If you take your money out of your 401(k) before age 59 1/2, even vested money, you will almost always owe a 10 percent early withdrawal penalty. Some of the few exceptions to this penalty are death, disability and leaving your employer after age 55. All 401(k) withdrawals are also subject to ordinary income tax.
After receiving a Bachelor of Arts in English from UCLA, John Csiszar earned a Certified Financial Planner designation and served 18 years as an investment adviser. Csiszar has served as a technical writer for various financial firms and has extensive experience writing for online publications.