The term “forfeiture” in a 401(k) plan speaks of the non-vested portion of the employer’s contribution to a participant’s account balance in the plan. For instance, if a participant is 40% vested in their account balance when he or she terminates or requests an early distribution, the remaining 60%, being the non-vested portion of the employer’s contribution in their account, will become a forfeiture.
As per the IRS, forfeitures can be utilized to reduce employer contributions, pay plan expenses, allocate to other participants in the plan, and/or restore previously forfeited accounts. Plan sponsors should use forfeitures in accordance with their plan documents. (Further explanation on how and when to use forfeitures can be found in our blog 401(k) Plan forfeitures – The Forgotten Funds.)
Note: Employer contributions referenced above that are subject to vesting in a 401(k) plan would include employer matching, discretionary, non-elective, and profit-sharing contributions.
Proposed regulations
On February 27, 2023, the IRS proposed the following regulations on forfeitures:
Forfeitures incurred under a defined contribution plan must be used within 12 months following the close of the plan year.
Under this rule, forfeitures incurred during any plan year that begins before January 1, 2024 are treated as having been incurred in the first plan year that begins on or after January 1, 2024; accordingly, those forfeitures must be used no later than 12 months after the end of that first plan year. These regulations are proposed to apply for plan years beginning on or after January 1, 2024.
Misconceptions around 401(k) plan forfeitures
- Application of forfeitures from multiple sources
In cases where 401(k) plans allow multiple types of employer contributions subject to the same or different vesting schedules (e.g., If the plan provides for employer match contributions as well as employer profit sharing contributions), the forfeitures from each type of employer contributions must be applied distinctly, as permitted in the plan documents. - Forfeitures – not a full loss!
If a participant is not fully vested in their portion of the employer’s contributions, they do not lose all of the money in their account or all the accumulated account balance, but only to the extent of unearned or unvested portion of the employer’s contributions. The participant is still eligible to receive the vested portion of the employer’s contributions. - Plan termination
It is not commonly known that a terminated plan must vest 100% of the employer’s contributions for all the current participants. An active participant who is 20% vested would automatically become 100% vested on the effective date of the Plan termination. In addition, when a 401(k) plan terminates, the plan sponsor must verify if unallocated amounts in the plan’s forfeiture account exists. It is the plan sponsor’s fiduciary responsibility to direct the use of such forfeitures account balance. For example, if the plan provisions state that the forfeitures must be used to reduce future employer contributions, and in the event of plan termination, it is confirmed that there is no possibility of future employer contributions, then at the option of the plan sponsor, the plan document is to be amended to insert guidance under such circ*mstances on use of the forfeited balance. - Non-applicability of forfeitures to certain distributions
Certain types of distributions are not subject to forfeitures, namely, upon attainment of normal retirement age and when the plan is terminated. In these cases, the employer contribution is 100% vested.
Infrequent uses of forfeiture balance
- Redistribution among remaining participants
As it is very important to zero out the forfeiture account at least once during the year in order to comply with the IRS guidelines, some 401(k) plans allow forfeiture balances to be reallocated or redistributed to the existing participants in the plan. The reallocations can be based on percentage or proportionate basis of a participant’s contributions, as defined by the plan. - Plan corrections
Where a 401(k) plan fails to comply with certain non-discrimination tests (such as Actual Deferral Percentage Test, Actual Contribution Percentage Test, Minimum Coverage Test, Top Heavy Test, etc.) applicable as per the regulatory requirements, it is permissible to use the forfeitures account balance to rectify errors identified in such non-compliance, if permitted by the plan document. This demonstrates that the plan is compliant with IRS regulations as well as enables avoidance of penalties. - Plan improvements
Apart from offsetting of plan expenses and utilization for future employer contributions being among the most common uses of forfeiture account balance, these funds can also be widely used to enhance the plan for the benefit of participants. Some ideas for plan improvisation would include introducing a Roth 401(k) feature, adding new investment options, and aiding participants with educational resources for informed decision making of their retirement savings. - Reinstating forfeited account balances
In case a terminated participant is re-hired and resumes employment under the same 401(k) plan, the previously forfeited account balance during his or her termination can be allowed reinstatement if specified in the plan document. If the current forfeitures are insufficient to reinstate the participant’s account balance fully, the employer shall contribute in cash for full reinstatement of the participant’s account balance to the extent previously forfeited.
Now that we have brushed up on our understanding of 401(k) plan forfeitures and its several misconceptions and infrequent uses, emphasis must be laid on how crucial it is to adhere to the plan’s design and the provisions outlined in the plan document. Ignorance of the plan terms would most likely attract consequences from the regulatory bodies on account of the plan’s operational deficiencies. Plan sponsors are expected to comply with the IRS and ERISA regulations and guidelines, as well as monitor the forfeiture account activity to be in line with plan provisions.
