Plan forfeitures occur when participants terminate employment before obtaining full vesting in their employer’s retirement plan. But what happens to the money these participants must forfeit? Forfeitures can be tricky, and the IRS monitors this area. Let’s take a look at what forfeitures are and how they work.
Set rules in plan document
When employers start a retirement plan, the plan document generally will contain provisions dealing with forfeitures. These are optional provisions that plan sponsors can include in the plan document. After these provisions are set, plan sponsors can’t change them without amending the plan.
With a plan amendment, you can adjust plan forfeiture provisions as long as the change doesn’t reduce a benefit already promised to a participant, also known as the “anticutback rule.” The amendment can change future forfeiture options, but it cannot change past or current forfeiture allocations. Be sure to work with your advisor regarding your plan provisions.
Use forfeitures for plan’s benefit
IRS rules require that plans return forfeiture amounts to the plan, not the employer. Forfeitures are plan assets, and sponsors must use them for the plan’s benefit. Plans may use forfeitures for the following purposes:
Pay plan expenses. If a forfeiture balance remains after paying administrative plan expenses, you must use the forfeitures to reduce employer contributions or provide an additional allocation to participants.
Reduce employer contributions. These contributions follow the formula defined in the plan document, which typically follows the employer funding formula. The plan document also will determine if you can use forfeitures for any type of employer contribution or if you must use them to fund the same money source that was forfeited. For example, some plan documents stipulate that you can use only match forfeitures to fund match contributions, and they cannot be applied to other employer contributions.
The IRS has offered guidelines on the types of employer contributions that you can fund with forfeitures. Generally, plan sponsors shouldn’t fund employer contributions that have mandatory 100% vesting — such as safe harbor contributions, qualified matching contributions (QMACs) and qualified nonelective contributions (QNECs) — with forfeiture money. The IRS views forfeitures as money that wasn’t fully vested and should be applied only to contributions that don’t require mandatory full and immediate vesting. However, even with this guidance, the IRS has approved documents that allow forfeitures to be used to reduce safe harbor contributions, QMACs and QNECs. Because the IRS hasn’t provided clear guidance, if your plan documents don’t specifically address this area, it’s important to work with your employee benefits advisors to fully understand the plan provisions.
Provide an additional allocation to participants. You can use forfeitures to provide an additional benefit to participants in addition to any fully funded employer contribution.
Distribute forfeitures in year accrued
Typically, plan sponsors must distribute forfeitures in the plan year the forfeiture accrues. However, your plan document can provide for an option to allow current year forfeitures to be used to reduce the next year’s contribution requirements. This is useful when a plan typically funds employer contributions before knowing what forfeitures are available, which can occur late in a plan year. Even though a plan may anticipate forfeitures, it still must fully fund current year contributions. Then, in the following year, the forfeiture money can be used to fund employer contributions.
As previously mentioned, forfeitures must be allocated in the year accrued or at least be used to fund next year’s contributions. But if the forfeitures exceed the contribution requirements, or exceed IRS Section 415 limits ($51,000 for 2013), the plan forfeiture may be held in a suspense account (an account that holds forfeiture money) to be used toward future allocations. These funds must be exhausted before the employer makes any additional plan contributions.
Don’t let forfeitures trip you up
It’s important that you and your advisor carefully monitor your plan’s forfeiture account. If you find that forfeitures weren’t distributed timely and appropriately, you can correct the mistake using the Employee Plans Compliance Resolution System. Using the IRS’s self-correction program, you must fix the mistake within two years following the close of the plan year in which the error occurred.
