Your 401(k): A vested interest

Question: My company's 401(k) vesting period is longer than I plan to stay at my job. Should I still invest in my 401(k) knowing that I will not receive any employer matching?
- Andrew, West Palm Beach, Florida

Answer: The short one is, Yes, you should still contribute to your 401(k) account even if there’s the chance that you may not get your employer’s matching funds.

But before I get into the reasons why, I want to make sure you and other people in your situation understand a bit about the ins and outs of vesting, which refers to the portion of your 401(k) that you actually own at any given time and that you get to take with you if you leave the company.

To begin with, I want to be perfectly clear that you are always 100% vested in all of the contributions you make to your 401(k), as well as all the investment earnings your contributions generate. That money is yours no matter what. Vesting requirements affect only the money your employer kicks in, as well as the investment earnings stemming from employer contributions.

You should also know that employers have some latitude in how quickly you vest. According to a 2007 survey by Hewitt Associates, about 44% of companies use immediate vesting. In other words, you’re always the owner of your entire account balance – your contributions, the employer’s and all earnings.

On a cliff or on a grade

Other companies employ either “cliff” or “graded” vesting. With cliff vesting you become the owner of all the employer’s contributions and any investment earnings of those contributions only after you’ve been at the company a certain number of years. Leave before that period and you get none of the employer’s matching funds.

Companies using cliff vesting used to be able to require that you stay as long as five years to be entitled to their contributions, but the Pension Protection Act (PPA) of 2006 lowered the maximum to three years.

Other firms employ “graded” vesting, which gradually gives you ownership of the company’s contributions and the earnings attributed to those contributions over a period of up to six years. (Prior to the PPA, the max was seven.)

That means if your 401(k) has five-year graded vesting (which is most common among plans with graded vesting) and you leave after three years, you would be entitled to three-fifths, or 60%, of your employer’s contributions and any earnings from them.

So before you make any assumptions about how much of your account balance is yours if you leave, I suggest you first check with your HR department to be sure you understand exactly how your plan’s vesting schedule works. You may find that you don’t have to stick around as long as you think to get most, if not all, of the portion of your balance resulting from your employer’s contributions.

You may also want to factor the vesting schedule into any plans you have to leave your job. After all, if your company has three-year cliff vesting and you’re within shouting distance of three years on the job, it may make sense to time your decision to leave so you can pick up those three years’ worth of employer contributions and their investment gains, if any.

The bottom line

Even if you think it’s unlikely you’ll end up with a single cent of what your employer chips in, however, I still think you’re better off participating in your company’s 401(k) than not.

Why? Well, your 401(k) is still a pretty sweet deal even if it has absolutely no provision for a company match. For starters, there’s the convenience of having your contributions automatically go from your paycheck into your 401(k) account. Given how much easier it is to spend than save, I don’t think you can overstate the value of putting your savings plan on autopilot.

And then there are the tax advantages. You get to invest pre-tax dollars, which lowers your current tax bill. And your contributions rack up returns without the drag of taxes. Yes, you’ll pay tax on your 401(k) kitty when you begin withdrawing the money at retirement. But by not having to pay taxes on gains during your career, you effectively earn a higher after-tax rate of return than you would in a taxable account, which means a larger after-tax value for your nest egg in retirement. (For an example, click here).

Granted, you could forego your 401(k) and get comparable tax benefits in a deductible IRA or a Roth IRA, assuming you qualify for them. But the maximum contribution amounts are much lower for IRAs: $5,000 this year, plus $1,000 if you’re 50 or older versus $15,500 plus $5,000 for 401(k)s (although some plans allow you to put away less).

Combine a 401(k)’s higher contribution limits with the ease of payroll deductions and the fact that there’s absolutely no chance of getting an employer match in an IRA, and you have a much better shot at building a large nest egg with a 401(k) than an IRA.

So as long as you’re still at this company, I suggest you participate in your plan. No matter when you leave, at the very least you’ll be assured of having the money you contributed, plus whatever it earns.

And if it turns out that you end up hanging around long enough to collect all or some of your employer’s match and investment gains from those funds, well, you can just think it as a little parting bonus from your old firm.

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