In the language of employee benefits, vesting refers to a milestone in which a promised benefit becomes "yours." Vesting helps a business hold onto valuable employees by requiring them to stay with the company for a few years to get the maximum benefit. The effect of vesting on your tax circumstances depends on the type of benefit involved.
How vesting works
With vesting, an employee earns benefits over time, rather than receiving them upfront. For example, a company might offer job candidates shares of stock if they accept an offer, but they will receive those shares only if they remain with the company a certain amount of time—six months, a year, 3 years, and other variations. Commonly vested benefits include:
- Shares of company stock
- Stock options
- Employer contributions to a 401k or other retirement savings plan
- The right to receive pension benefits
Benefits generally vest in one of two ways:
- In "cliff vesting," you receive the entire benefit all at once when you reach a certain date.
- In "graded vesting," you receive the benefit in increments, for example 20% a year for five years until benefit fully vest.
Tax status of benefits
The vesting of a benefit creates tax consequences only if what you receive is itself taxable. For example, employer contributions to a 401(k) plan are generally untaxed, because in a 401(k), you pay taxes only on money you withdraw from your account.
If your employer contributes $100 to your 401(k), it doesn’t matter whether you have full rights to the money immediately or have to wait for that contribution to vest: The money is not taxed, so you don’t report it on your tax return.
On the other hand, if your employer gives you a share of stock, it’s taxable compensation whenever you receive the stock—now, or whenever it vests.
- When taxable benefits are cliff vested, you report the full amount as income in the year you reach the vesting date.
- When taxable benefits are subject to graded vesting, you report only the value that vested in that year as income.
Reporting benefits as income
Employers must report all taxable benefits to their workers on Form W-2. This is the form you get in the mail from your employer telling you how much you earned the previous year and how much was withheld in taxes. Taxable benefits that you received or that vested the previous year will be included in Box 1 of the W-2.
You might receive a separate W-2 specifically for your taxable benefits, or those benefits might be included on the same W-2 as your wage or salary income. Either way, report taxable benefits on your tax return the same way you would your regular wages—on the line marked for wages, salaries, tips, etc. Your employer should have also withheld taxes to cover the benefit. Those taxes will be reported on the W-2, as well.
If your vested benefits are nontaxable, they won't appear on your W-2, and you have nothing to report on your tax return that year.
Stock options and vesting
One of the most common benefits subject to vesting periods is stock options. A stock option gives you the right to buy company stock at a specific price, called the exercise price or strike price. If the market price of the stock is higher than the strike price when you exercise the option (meaning, when you use the option to buy stock), then you make a profit.
There are two basic types of stock options: incentive options and nonstatutory options. Each gets taxed differently. However, vesting does not create a tax liability with either kind of option. In general:
- With incentive options, you are not taxed when the options vest or when you exercise the option. When you sell the stock you bought with the option, you pay capital gains taxes.
- With nonstatutory options, you also are not taxed when the options vest. When you exercise the option, the difference between the strike price and the market price is taxed as income. When you sell the stock, you pay capital gains taxes.