What Happens to 401k Money That Is Not Vested?
Understand what happens to unvested 401(k) funds, how vesting schedules impact your balance, and what employers do with forfeited contributions.
Saving for retirement through a 401(k) is common, but not all the money in your account is immediately yours. Employer contributions often come with conditions that determine when you fully own them. This process, known as vesting, affects how much of your balance you take with you if you leave your job.
Vesting Timelines
The schedule for gaining full ownership of employer contributions varies by company and is regulated by federal law. Some employers offer immediate vesting, while others require a set period of employment before you can claim the full amount.
A common approach is graded vesting, where ownership increases gradually. For example, a company might allow you to keep 20% of its contributions after one year, 40% after two years, and so on until you reach 100%. This structure encourages employees to stay longer.
Another method, cliff vesting, delays full ownership until a specific point. If a company has a three-year cliff vesting schedule, you receive nothing if you leave before the third year but gain full rights to the funds once that milestone is reached.
Federal law limits how long companies can delay full vesting. Under the Employee Retirement Income Security Act (ERISA), graded vesting cannot extend beyond six years, and cliff vesting must not exceed three years. These rules ensure employees have a reasonable opportunity to earn their benefits.
Employer vs. Employee Funds
A 401(k) consists of contributions from both the employee and the employer. Employee contributions are always fully owned by the worker. These funds, deducted from a paycheck, grow tax-deferred in a traditional 401(k) or tax-free in a Roth 401(k), depending on the plan type. Employees can roll over their contributions to another retirement account or withdraw them, subject to taxes and penalties, if they leave their job.
Employer contributions may be subject to vesting schedules. These funds, typically added through matching programs or profit-sharing, provide an incentive for employees to stay. If an employee leaves before becoming fully vested, they may forfeit some or all of these contributions.
Employer and employee funds also differ in terms of loans and hardship withdrawals. Employees can generally borrow from their vested balance, but employer contributions may not always be included in the loanable amount, depending on the plan’s rules. Hardship withdrawals, meant for urgent financial needs, are often restricted to employee contributions.
Forfeiture and Corporate Use
When an employee leaves before becoming fully vested, any unvested employer contributions are forfeited back to the employer. These funds can be used in different ways, depending on plan rules.
One common use is to offset future employer contributions. If a company is required to match $500,000 in contributions for a given year but has $100,000 in forfeitures, it may only need to contribute $400,000 in new funds.
Forfeited funds can also cover administrative costs associated with maintaining the 401(k) plan, such as recordkeeping, compliance testing, and investment management. Rather than passing these costs on to employees, companies may use forfeitures to absorb some or all expenses.
In some cases, forfeitures may be redistributed to remaining plan participants. While less common, some 401(k) plans specify that unvested funds should be reallocated among employees still actively contributing. This redistribution is typically done proportionally based on account balances.
Tax Treatment of Unvested Amounts
Unvested employer contributions are not considered taxable income because the employee does not yet own them. The IRS only recognizes taxable events when funds become vested or distributed. If an employee leaves before vesting, the forfeited amounts never appear on their tax return.
Once an employer contribution vests, it is treated as part of the employee’s retirement assets and becomes subject to the same tax rules as other 401(k) funds. If a vested amount is withdrawn before age 59½, it is taxed as ordinary income and may also incur a 10% early withdrawal penalty under IRC 72(t) unless an exception applies.
For traditional 401(k) plans, required minimum distributions (RMDs) apply starting at age 73, as mandated by the SECURE 2.0 Act of 2022. These withdrawals are taxed at the individual’s marginal rate.