Since an ESOP is a qualified defined contribution plan, it needs to follow the vesting rules described in IRC Section 411(a)(2)(B), which provides a plan must use a schedule at least as beneficial as the 3-year cliff vesting schedule or the 6-year graded vesting schedule for employer discretionary contributions.
|3-Year Cliff Schedule||6-Year Graded Schedule|
|Year||Vested %||Year||Vested %|
A participant's vested account balance is their account value multiplied by their vested percent. Sound simple? Be careful to know what your plan document says, as there are a couple different provisions that may apply to your plan.
Year of Service
The plan document defines a year of service for vesting purposes. The most common approach is using an Hours of Service definition that requires 1,000 hours to get credit for a year of vested service. The other less common approach is using Elapsed Time, where the plan administrator needs to track days worked to compute years of vested service. This can become quite cumbersome if your company has rehires in the workforce.
Service Prior to the Effective Date
The ESOP may give credit for years prior to the start of the plan, or even partial credit. This allows employees with prior service with the company to vest quicker, providing them a jumpstart on their vested account balance.
The Pension Protection Act of 2006 reduced the minimum required vesting schedules from the 5-year cliff or the 7-year graded schedule. The new schedules were effective for plan years beginning in 2007 or later. Depending on the terms of your ESOP document, some accounts may still be using the older vesting schedules for the pre-2007 account values.
Special Clause for ESOPs
PPA 2006 allowed ESOPs to continue applying the pre-PPA vesting schedules if the ESOP had an outstanding loan on September 26, 2005, which was incurred for the purpose of acquiring qualifying employer securities. The accelerated vesting schedules must be used in the plan year following the earlier of:
the date on which the loan is fully repaid, or
the date on which the loan was, as of September 26, 2005, scheduled to be fully repaid.
It is important to track accounts separately for vesting purposes, as account balances can have different vesting schedules. Be sure to understand how your ESOP document is drafted to determine the correct vested balances for your plan participants.