by: Nicole Figliolo, CPC, QPA, QKA
What are plan forfeitures?
In a Defined Contribution plan, such as a 401(k), assets are considered forfeited when a participant separates from service before they are 100% vested. Since employee contributions are always 100% vested, forfeitures can only arise from employer contributions.
The nonvested portion of a participant’s account balance becomes a forfeiture at the earlier of:
1) Distribution of the vested account balance, or
2) The end of five consecutive one-year breaks in service.
If an employee terminates from employment and their entire account balance consists solely of unvested employer contributions, then under most plans’ rules, they are considered to have received a “zero-dollar cash-out” and their entire balance is forfeited immediately upon termination.
It is important to note that when a participant terminates and requests a distribution of their assets, any unvested money is forfeited upon distribution and moved to the plan’s forfeiture account. However if the participant is later rehired, they must be offered the option to repay the distribution and have the forfeited money restored to their account. If the plan’s forfeiture account does not have enough money to restore the participant (because forfeitures were used as described below), then the employer must make an additional contribution to make the participant whole.
What’s changed?
In 2023, the IRS published a notice of proposed rulemaking, notifying the public that they are planning to update the forfeiture regulations, which were last issued in 1963. Among other changes, the proposed regulations explicitly require all plans to use forfeitures within 12 months following the end of the plan year in which the forfeiture occurred. This timing rule has been included in preapproved plan documents for many years, however, the IRS recognizes that many plans have not strictly complied with it. In order to ease compliance, the proposed regulations have provided a generous grace period. Under the proposed rule, all forfeitures from 2024 or earlier will be considered compliant as long as they are used no later than December 31, 2025.
How are forfeitures used?
Depending on the plan document, forfeitures may be applied to:
1) Pay certain plan administrative expenses,
2) Reduce employer contributions, or
3) Increase benefits in other participant’s accounts.
The IRS has stated any violation would be considered an operational failure if only one use of forfeiture is selected and the forfeitures exceed the amount that can be used for that one purpose. Therefore, it is best practice to provide more than one method in your Plan Document.