Sponsors of 401(k) plans often fail to timely use or allocate forfeitures, thereby potentially disqualifying the plan. Recent IRS audits have revealed a renewed focus on the proper use of forfeitures – making compliance a top priority for plan sponsors.
Forfeitures are generally created when a participant leaves employment before completing the period of service needed to become fully vested in matching or other employer contributions. The non-vested portion of the participant’s account may then be forfeited. (In practice, many plans specify that the forfeiture occurs only after the participant has incurred five consecutive one-year breaks in service.) Some plan sponsors or third party administrators (“TPAs”) then place the forfeited amounts into a plan’s suspense account, allowing the forfeitures to accumulate over a period of several years. This practice is impermissible.
The IRS requires that forfeitures be used or allocated for the plan year in which they arise or, in appropriate circumstances, the following plan year. Forfeitures may be used to (1) pay a plan’s reasonable administrative expenses, (2) reduce employer contributions, (3) restore previously forfeited participant accounts, or (4) provide additional contributions to participants. The plan document must clearly define how and when forfeitures will be used. (Note: The IRS has recently taken the position that forfeitures cannot be used to fund 401(k) safe harbor contributions, because those contributions must be 100% vested when made to the plan. Future guidance is expected on this issue, however.)
Among the most common reasons for failing to timely allocate forfeitures are the following:
- A plan sponsor or TPA fails to monitor the plan’s forfeiture account to ensure that forfeitures generated during a plan year are used according to the plan’s terms.
- A plan sponsor and TPA both assume that the other party will be taking care of the forfeitures – and neither does so.
- A plan sponsor erroneously assumes that it has discretion over how and when forfeitures held in a suspense account are to be applied.
- A plan’s terms are vague in describing how forfeitures are to be handled.
- A plan sponsor elects not to make a discretionary contribution for a plan year and, because there are no contributions to offset with forfeited amounts, the sponsor fails to allocate the forfeitures.
- A plan sponsor pays administrative expenses directly or through revenue sharing, without thinking to use forfeitures to pay those expenses.
This common plan mistake may be corrected by reallocating all forfeitures in the plan’s forfeiture suspense account to any participants who should have received them had the forfeitures been allocated on a timely basis. Depending on the plan’s terms, or on the facts and circumstances of a particular situation, it may also be appropriate to apply forfeitures from prior years as an employer contribution for the current year.
Plan sponsors may correct this mistake under the IRS’s Employee Plans Compliance Resolution System (“EPCRS”). Under the EPCRS’s Self-Correction Program, the mistake must generally be corrected within two years following the close of the plan year in which it occurred (unless the failure can be classified as insignificant). The Voluntary Correction Program (“VCP”) must then be used after this two-year period. VCP must also be used if the plan’s terms are defective and must be retroactively corrected through a plan amendment. (See our March 2012 article for more information on the various correction methods available to plan sponsors under EPCRS.)
Finally, here are some suggestions for plan sponsors looking to avoid this common plan mistake:
- Review your plan document to ensure that there are clear procedures in place for the timing and use of forfeitures – and follow those procedures. If there are no procedures, or if they are vague, amend the plan document to add or clarify them.
- Review the forfeiture suspense account at least annually to verify that forfeitures are actually being used or allocated.
- Communicate with your TPA or recordkeeper to avoid any uncertainty as to whose responsibility it is to handle forfeitures.