Financial Impacts of 401(k) vesting requirements

Many people with unvested 401(k) contributions, who lose or change jobs for a wide variety of reasons, end up losing retirement wealth. Should workers with unvested benefits choose to forego 401(k) plans in favor of Individual Retirement Accounts or Health Savings Accounts? Should 401(k) vesting requirements be eliminated to better assist workers who are struggling to save for retirement?

Employer matching contributions are often called “free money.” Virtually, all financial advisors recommend workers take full advantage of employer matching contributions to 401(k) plans.  

However, workers at firms with 401(k) plans with vesting requirements do not immediately own the employer match.  

Information on the prevalence of 401(k) vesting requirements is found here.

  • Around 56 percent of plans have vesting requirements which delay receipt of the ownership of the 401(k) match. 
  • Around 30 percent of firms use a graded vesting schedule where the employer match vests over a five or six year period.
  • A saver with a 401(k) plan that has three-year cliff vesting will lose all benefits unless she stays at a firm for three years.

Many workers especially young adults will leave the firm prior to fully vested and will lose some or all the unvested employer matching contributions.  The high level of job mobility, especially among young adults, leading to a likely loss of some retirement wealth due to vesting requirements, is documented by this BLS report.

  • Americans born in the early 1980s had an average of 7.8 jobs between age 18 and 30.
  • Young adults from age 27 to 30 had on average 2.2 jobs during that period of life.

There are many reasons why people leave one job for another.  In 2022, 50 million people quit their jobs, there were 15.4 million layoffs and 40 percent of Americans had been laid off or terminated from a job at least once in their life.  A recent Gallup report found that 60 percent of respondents reported they were emotionally detached at work and that 19 percent of respondents reported being miserable.  

All workers with unvested 401(k) contributions who switch jobs will lose retirement wealth due to the change in their employment status, regardless of the reason for the switch in jobs.  

People in a work situation where their place of employment offers a 401(k) plan with slowly vesting employer contributions should forego contributions to the firm-sponsored 401(k) plan and consider some other tax-preferred investment vehicle.

Investments in Individual Retirement Accounts and Health Savings Accounts are both preferable to investment in a 401(k) plan when the receipt of matching contributions is uncertain.

Individual Retirement Accounts often have lower fees than 401(k) plans and the fee differential can result in a large loss of lifetime income as discussed here.  The use of short-term bond and CD ladders inside an IRA can substantially reduce risks associated with interest rate changes compared to investments in bond ETFs inside a 401(k) plan.

Health Savings Accounts allow for an immediate tax deduction, are available for immediate health expenses without penalty or tax and provide penalty-free access to all funds after age 65.  The use of funds in a Health Savings Account reduce medical debt and the number of people forgoing necessary medical procedures.  Finance tip number eight states that contributions to health savings accounts must take on a high priority even at the expense of contributions to 401(k) plans.

The Secure Act 2.0 mandated automatic enrollment for new workers inside 401(k) plans.  The existence of vesting requirements creates an incentive for savvy workers to opt out of their 401(k) plans.

There are compelling arguments for a new law outlawing all vesting requirements on firm 401(K) plans, even if this change increases turnover and training costs for some firms.   Taking money from an employee that the employer chooses to terminate or leaves because she is miserable seems unfair and is a recipe for low productivity.  The next generation of workers is likely to have a higher Social Security retirement age because of pending Social Security deficits.   The forfeiture of employer contributions because of vesting requirements will reduce the accumulation of retirement wealth. 

It is time for policy makers to abolish 401(k) vesting requirements.  People currently subject to 401(k) vesting requirements need to consider other investment options.

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