As an employee of a company, you may have heard the term “vesting schedule” in relation to your employer’s retirement plan or stock options. Vesting schedules are a common tool used by employers to incentivize employees to stay with the company for a certain period of time. But what exactly is a vesting schedule, and how does it impact your taxes?
A vesting schedule is an agreed-upon timeline that determines when an employee becomes entitled to receive benefits from their employer’s retirement plan or stock option grants. For example, if an employer has a four-year vesting schedule on its 401(k) plan, then after four years of service, the employee would be fully vested and entitled to all contributions made by the employer.
When it comes to taxes, there are two main types of vesting schedules: cliff vesting and graded vesting.
Cliff Vesting
In cliff vesting, an employee becomes fully vested in their retirement plan or stock options after completing a set number of years of service (usually three to five). The benefit here is that once you reach that threshold time limit, you become fully vested all at once – hence the name “cliff.” This means that you immediately own 100% of any contributions made by your employer.
From a tax perspective, this can be advantageous because any gains earned on those investments will be taxed as long-term capital gains if they’re held for more than one year. Long-term capital gains are taxed at lower rates than short-term capital gains – which are taxed at ordinary income tax rates.
Graded Vesting
With graded vesting schedules, employees gradually become vested over time instead of all at once. For example, under a three-year graded-vested system for stock options granted today:
Year One: 33% becomes vested (1/3)
Year Two: An additional 33% vests (2/3 total)
Year Three: Remaining 34% vests (fully vested)
With graded vesting, the longer you stay with your employer, the more benefits you’ll accrue. This can be a great incentive to encourage employee retention.
From a tax perspective, any gains earned on investments that are sold within one year of being granted will be taxed as short-term capital gains and subject to ordinary income tax rates. Any gains earned on investments held for more than one year will be taxed as long-term capital gains.
When it comes time to sell or exercise stock options, keep in mind that there may also be additional taxes owed beyond capital gains taxes. For example, if you exercise your stock options and then sell them immediately (also known as a “cashless exercise”), you’ll owe both ordinary income tax and payroll taxes on the difference between the market price at exercise and the grant price.
In conclusion, it’s important to understand your employer’s vesting schedule for retirement plans or stock option grants. Depending on whether they use cliff or graded vesting schedules, this could impact when you become fully vested in these benefits – which can have an impact on how much of those investments is subject to taxation. It’s always best to consult with a financial advisor or tax professional before making any decisions regarding exercising stock options or selling assets gained through retirement plans.