Vesting is the point at which a person’s right to compensation or a benefit stops being forfeitable, so the right survives the end of the service relationship. Before that point the right can still be lost by leaving, or by failing whatever condition the plan or the award attaches to it. After it, the right belongs to the person whether they stay or not.
Federal pension law states the standard the word points at. A nonforfeitable pension benefit or right is a claim obtained by a participant or a beneficiary to that part of an immediate or deferred benefit under a pension plan which arises from the participant’s service, which is unconditional, and which is legally enforceable against the plan (29 U.S.C. 1002(19)). The same paragraph adds that a right to an accrued benefit derived from employer contributions is not treated as forfeitable merely because the plan contains a provision described in section 1053(a)(3), so the forfeitures and suspensions that section permits do not break the definition.
Two Senses, Two Sets of Rules
A CPA firm sees this word in two places, and the two are not governed by the same authority. One is retirement plan vesting, where a participant earns a nonforfeitable right to employer money on a schedule Congress caps. The other is equity and property vesting, where stock or other property transferred for services becomes taxable to the recipient once it is either transferable or no longer subject to a substantial risk of forfeiture, which is a wider trigger than the forfeiture risk lifting on its own. The schedules belong to the first sense and the tax timing to the second, so a rule imported from one into the other will be wrong.
Retirement Plan Vesting
Money the employee put in is never on a schedule. A qualified plan has to provide that an employee’s rights in the accrued benefit derived from the employee’s own contributions are nonforfeitable (26 U.S.C. 411(a)(1)).
The same holds for elective deferrals. A qualified cash or deferred arrangement has to provide that an employee’s right to the accrued benefit derived from employer contributions made to the trust pursuant to the employee’s election is nonforfeitable (26 U.S.C. 401(k)(2)(C)). A 401(k) contribution the employee elected is fully vested the day it goes in, and no schedule touches it.
The Schedules Employer Contributions Have to Meet
Employer contributions are what a vesting schedule actually governs. A defined contribution plan satisfies the minimum standard one of two ways. Under 3-year vesting, an employee who has completed at least 3 years of service has a nonforfeitable right to 100 percent of the accrued benefit derived from employer contributions. Under 2 to 6 year vesting, the nonforfeitable percentage is 20 at 2 years of service, 40 at 3 years, 60 at 4 years, 80 at 5 years, and 100 at 6 or more (26 U.S.C. 411(a)(2)(B)).
A defined benefit plan gets a longer runway. Under 5-year vesting, an employee who has completed at least 5 years of service has a nonforfeitable right to 100 percent of that accrued benefit. Under 3 to 7 year vesting, the nonforfeitable percentage is 20 at 3 years of service, 40 at 4 years, 60 at 5 years, 80 at 6 years, and 100 at 7 or more (26 U.S.C. 411(a)(2)(A)).
Those are the outer limits section 411 allows rather than required designs, so a plan is free to vest faster and immediate full vesting satisfies the standard. The labor-law side carries the same two pairs of schedules in the same words, with individual account plan standing in for defined contribution plan, which is why one rule gets cited both as ERISA section 203 and as section 411 of the Code (29 U.S.C. 1053(a)(2), 26 U.S.C. 411(a)(2)).
The IRS names the two shapes these schedules take. A schedule that turns the whole employer-derived balance nonforfeitable on a single date is cliff vesting, and a schedule that raises the nonforfeitable percentage step by step is graded vesting (Retirement topics - Vesting). In the Code’s own labels the cliff shape is 3-year vesting or 5-year vesting, and the graded shape is the 2 to 6 year or the 3 to 7 year table (26 U.S.C. 411(a)(2)).
Say a plan uses the 2 to 6 year graded schedule and a participant leaves after four completed years of service. At that point 60 percent of the employer money is nonforfeitable and the remaining 40 percent is still forfeitable (26 U.S.C. 411(a)(2)(B)). On stated inputs the split falls out like this.
Employer contributions credited 18,000
Completed years of service 4
Nonforfeitable percentage at 4 years 60%
Nonforfeitable amount 18,000 x 0.60 10,800
Forfeitable amount 18,000 - 10,800 7,200Equity and Property Vesting
Section 83 of the Code governs property transferred in connection with the performance of services. It never names a vesting date; it fixes the moment the value becomes taxable. The excess of the property’s fair market value over the amount paid for it is included in the service provider’s gross income in the first taxable year in which the rights are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. That fair market value is fixed at the first time the rights are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, so the amount taxed is the value on that date and not the value at the transfer (26 U.S.C. 83(a)).
The regulation supplies the vocabulary the practice uses. Property is substantially nonvested when it is subject to a substantial risk of forfeiture and is nontransferable, and it is substantially vested when it is either transferable or not subject to a substantial risk of forfeiture (26 CFR 1.83-3(b)).
Except as paragraphs (j) and (k) of that section provide, a substantial risk of forfeiture exists only if rights in the transferred property are conditioned, directly or indirectly, on the future performance or refraining from performance of substantial services by any person, or on the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial (26 CFR 1.83-3(c)(1)).
Several things that look like forfeiture risk are not. The risk that the property will decline in value over a period of time does not create one. Neither does a forfeiture condition that the facts and circumstances show is unlikely to be enforced. A nonlapse restriction, which paragraph (h) of the same section defines as a permanent limitation requiring the holder to sell the property at a price set by a formula and binding on any later holder, will not result in one standing by itself. A restriction on transferring the property creates one only if and to the extent the restriction is described in paragraph (j) or (k) of that section (26 CFR 1.83-3(c)(1)).
The Section 83(b) Election
A recipient can move the tax to the transfer date instead of waiting for the risk to lift. The person who performs the services may elect to include in gross income, for the taxable year in which the property is transferred, the excess of its fair market value at the time of transfer over the amount paid, and the election must be made not later than 30 days after the date of the transfer (26 U.S.C. 83(b)). If the election is made and the property is later forfeited, no deduction is allowed for that forfeiture.
The IRS publishes a form for the election. Form 15620 is the Section 83(b) Election form. It goes by mail to the IRS office with which the service provider files a federal income tax return, a copy goes to the person for whom the services are performed, and where the service provider and the transferee of the property are not the same person a copy goes to the transferee as well. A written statement meeting the regulation’s requirements remains an alternative to the form (Form 15620).
Vesting in the Accounting Records
On the reporting side the word sets a period rather than a date. Where an award classified as an equity instrument is not fully vested at the grant date, compensation cost is recognized as services are rendered over the requisite service period under FASB ASC Topic 718 (SEC Staff Accounting Bulletin Topic 14). The vesting terms written into an award agreement therefore drive the expense pattern in the accounts, not only the recipient’s entitlement.
Where a Firm Runs Into It
In a plan engagement the vesting schedule is plan-document data, and participant vested balances get tested against it as one input inside the wider employee benefit plan audit. On the compensation side, accrued vacation is the everyday case where whether the rights vest decides if a liability belongs on the books, and accruals carries that condition in full. Amounts that become includible when property vests are compensation for services and land in payroll reporting, which gross wages covers. Where the award is a stock right rather than restricted stock, the deferred compensation rules add a separate test, set out in share appreciation right.
Vesting Is Not a Clawback
Vesting is a right becoming unforfeitable going forward. A clawback pulls back money that has already been handed over. One settles whether a person keeps what they earned; the other recovers what they were already paid.
Common Questions About Vesting
It means a right has stopped being forfeitable. In a pension context that is the point at which the claim to the benefit is unconditional and legally enforceable against the plan (29 U.S.C. 1002(19)).
Take restricted stock granted to an employee and forfeited if that employee leaves within three years. Until the condition lapses the stock is substantially nonvested, because it is subject to a substantial risk of forfeiture and is nontransferable (26 CFR 1.83-3(b)). Nothing goes into income until the rights are transferable or no longer subject to that risk, whichever comes first (26 U.S.C. 83(a)).
The same thing it means today. If a person says they were vested in a former employer’s plan, their right to the employer contributions had already become nonforfeitable by the time they left, so leaving did not cost them the balance.
That depends on which kind of plan. Under a defined benefit plan using 5-year vesting, 5 years of service carries a nonforfeitable right to 100 percent of the accrued benefit derived from employer contributions. Under a defined contribution plan using the 2 to 6 year graded schedule, 5 years of service carries 80 percent, and the remainder arrives at 6 years (26 U.S.C. 411(a)(2)).
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