Retirement plan forfeitures in participant-directed 401(k) plan accounts have been a hot topic this year, primarily due to the number of Employee Retirement Income Security Act (ERISA) class action lawsuits related to the usage of forfeitures and whether that usage was a fiduciary breach (which is what the 20+ lawsuits allege). To comprehend the forfeiture landscape, it is important to understand how forfeitures arise, how they may be used according to Internal Revenue Service (IRS) regulations, and the plan document provisions that dictate how and when a specific plan’s forfeitures must be used.

In addition to forfeiture basics, this post provides a high-level overview of the recent forfeiture litigation, including all the fuss that has been caused across the retirement plan industry and specifically to 401(k) plan fiduciaries. The crux of the matter is that the litigating plaintiffs seek to use Department of Labor (DOL) regulations to trump the longstanding permitted usage of forfeitures under the IRS rules. This post also reviews important considerations and best practices for plan committees to mitigate risk.

401(k) plans that include vesting schedules on employer contributions will inevitably accumulate forfeitures and confront the challenging decision of how to allocate those funds. Forfeitures cannot accumulate in the plan and must be used according to the plan document terms to prevent qualification failures. Depending on the size of the plan sponsor and the turnover rate of employees, forfeiture account balances can be significant. As long as one of the IRS permitted uses of forfeitures was followed and the forfeitures were timely allocated, usage of plan forfeiture accounts has historically been left to the employer’s discretion.

If using the forfeitures was not enough to worry about, now plan sponsors and fiduciaries need to consider whether the method used to deplete the forfeiture account is a settlor or fiduciary decision. To reiterate, the methodology for usage of plan forfeitures has traditionally always been under the oversight of the IRS (not the DOL). However, recent litigation under ERISA has brought renewed attention to the fiduciary considerations in how forfeitures are managed, and the implications for both employees and employers.

Before panic sets in and you stop reading to go check the forfeiture account balance in your plan, this post provides a basic understanding of the standard IRS rules, as well as the ERISA fiduciary considerations that may keep the litigation attorneys at bay.

How Forfeitures Occur

Forfeitures occur when a partially vested participant receives a distribution from the plan upon termination of employment or when a participant has been terminated for five consecutive years but chooses to the leave their account balance in the plan. The latter is known as the five-year break in service rule which is a common default plan provision (a five-year break in service is five consecutive computation periods in which an employee works less than 501 hours in each 12-month computation period). If the plan document contains forced cash out provisions, small account balances under a certain threshold may be forced out of the plan without the participant’s consent.

Let’s review a few examples:

• Example 1 – Participant elects a distribution upon termination of employment:
  John participates in a company 401(k) plan that provides a matching contribution subject to a graded vesting schedule (20% after 2 years, then 20% each year thereafter, fully vested at year 6). John terminates employment after 4 years with the company and is 60% vested in his employer match account of $10,000.
  
  John decides to rollover his account balance to his new employer’s 401(k) plan and will receive 100% of his deferral account balance and 60% of the match balance ($6,000). The remaining $4,000 will be forfeited and will be transferred to the forfeiture suspense account.

• Example 2 – Forfeiture following a 5-year break in service:
  Same facts as above, but John decides to leave his account balance in his prior employer’s 401(k) plan. John terminated in 2019. At the end of 2024, he will have incurred 5 consecutive one-year breaks in service.
  
  John’s prior employer’s 401(k) plan includes the 5-year break in service rule, and at the end of 2024 the plan’s recordkeeper automatically forfeits the non-vested portion of the account ($4,000) and transfers that amount to the forfeiture suspense account. The remaining amount in John’s account is now fully vested, and he may leave the account in the plan until there is a required distribution event (generally upon the attainment of the applicable required minimum distribution age or death).

• Example 3 – Forfeiture following forced cash out of small account balances:
  Same facts as above, but John’s total vested account balance in the plan is only $3,000 of which $2,000 is deferrals and $1,000 is employer match. His non-vested match is $400 (40% of $1,000).
  
  John’s prior employer’s plan includes a cash out provision that requires a forced distribution (John’s consent not required) if the vested account balance is under $7,000 (note: some plans may have a lower cash out limit).
  
  The prior employer provides John with the opportunity to take a distribution, but John does not elect to do so. Under the cash out provisions of the plan document, the plan forces the vested portion of John’s account ($2,600) to an IRA and forfeits the non-vested portion of $400.

Forfeitures may also arise out of uncommon situations other than non-vested accounts of terminated participants. For example, if there is a correction to an excess allocation made to a participant’s employer contribution account, that excess will be transferred to the forfeiture account. Similarly, if there are corrections due to a failed nondiscrimination test, those amounts attributable to employer contributions may be transferred to the forfeiture account.

Forfeiture Account Usage Options

With this understanding of how money gets deposited into the forfeiture suspense account, let’s review the IRS approved methods for forfeiture usage (not in any particular order).

Permissible Applications of Forfeitures

• Pay Administrative Expenses – Forfeitures may be used to pay regular administration fees necessary for the operation of the plan.

• Reduce Employer Contributions – Forfeitures can be used to reduce the employer’s matching or profit sharing (aka non-elective) contributions and may also reduce employer safe harbor contributions.

• Restore Previously Forfeited Accounts of Rehires – Forfeitures may be used to restore accounts of a rehired employee who previously forfeited non-vested monies.

• Reallocate as Employer Contributions – Forfeitures may be allocated according to the plan provisions as additional discretionary contributions. However, any reallocated forfeitures count in the annual additions limitation under IRC §415(c) for the plan year.

• Reduce QNEC/QMAC Contributions – Forfeitures may be used to reduce QNEC/QMACs necessary to satisfy the ADP/ACP Testing.

Plan Provisions Addressing Forfeitures

There are options for depleting the forfeiture account; however, not all plan documents contain the same provisions as it relates to forfeiture usage. The key point here is that the plan document for a specific 401(k) plan should always be reviewed before utilizing the forfeitures.

Plan service providers sponsor IRS pre-approved plan documents and generally customize the defaults to meet their standard procedures. The plan language may vary among service provider standard terms, so here are a few examples:

• Service Provider 1 – Forfeitures may be used to pay administrative expenses at any time, if directed by the Administrator. Any forfeitures not used to pay expenses under the Plan shall be applied to reduce employer contributions. (Note: The employer may designate differently in the Adoption Agreement).

• Service Provider 2 – Forfeitures may be used to reinstate previously forfeited balances or to satisfy any required contributions in the Adoption Agreement. Other permissible applications may be selected in the Adoption Agreement and does not require that all of the available options be selected.

• Service Provider 3 – Forfeitures shall be used to restore forfeited accounts or reduce Employer contributions (or reallocate), or to pay reasonable plan expenses to the extent specified in the Adoption Agreement.

• Service Provider 4 – Forfeitures will be used to restore forfeited account balances or reduce any required contributions, or to pay any plan expenses. The Employer must direct the Administrator to use any remaining forfeitures in accordance with any combination of the following methods: 1) added to any discretionary contribution 2) used to reduce any employer contribution 3) added to match as an additional contribution 4) allocated proportionately on eligible compensation.

Forfeiture usage, and the order of the usage, may be determined by the employer as a settlor function when establishing or amending the plan. As a practical note, if the plan document states that forfeitures may only be used to reduce employer contributions (i.e., not permitted to pay fees) or vice versa, employers will not face any ambiguity in the forfeiture allocation decision-making process—the required approach is simply set by the plan terms. Another consideration for prudent plan design is to state the order in which forfeitures will be applied when multiple options are available under the terms of the plan.

Forfeiture Account Timing of Usage

Forfeiture account balances are often overlooked and may cause qualification failures if allowed to accumulate without being used by the appropriate deadline. Generally, forfeiture account balances must be used by either the end of the plan year in which they arose, or by the end of the plan year following the plan year in which they arose. Most plan documents include the more liberal latter deadline (i.e., the plan year following the plan year the forfeiture arose), but employers should always be careful to confirm this by reviewing the specific plan document provisions.

Note that in 2023, the IRS issued proposed forfeiture regulations suggesting a new limitation that forfeitures must be used within 12 months following the plan year they arose, however those regulations have not been finalized as of the date of this post. The proposed regulations included a surprise transition rule that would treat all forfeitures that occurred before January 1, 2024, as having occurred in the 2024 plan year (assumes a calendar year plan year), so that all prior accumulated forfeitures could be depleted by December 31, 2025 without a qualification failure. That type of relief would be a huge win for plans with a large forfeiture account balances accumulated over numerous years, in effect providing a “free pass” on the prior qualification failures if the accounts are depleted by December 31, 2025.

While the forfeiture regulations have not been finalized, the Proposed Applicability Date in the IRS’ proposed regulations do state that taxpayers may rely upon the proposed forfeiture regulations for periods preceding the applicability date (plan years beginning on or after January 1, 2024). Employers should consult with ERISA counsel to confirm the interpretation and how the proposed regulations impact the specific plan.

Prior to the proposed regulations, unwinding forfeiture accounts had a ripple effect on plan administration, because most plan documents require that unused forfeitures be reallocated to plan participants for the year they should have been used. Unfortunately, that requires reopening accounts of terminated participants who no longer have an account balance in the plan. Alternatively, the plan sponsor could request a formal approval from the IRS under the Voluntary Compliance Program (VCP) to reallocate those forfeitures to current participants only. Because that is not what the plan document states, the employer must get approval from the IRS to reallocate to a different target group.

Forfeiture Litigation

Recent ERISA litigation has focused on how forfeitures are handled and the potential consequences for plan fiduciaries. Central to the litigation is the manner in which forfeited funds have been utilized, primarily arguing that the decision to apply the forfeitures to reduce employer contributions—rather than offsetting plan fees that are charged against participant accounts—is not acting in the participant’s best interest. Not putting the participants’ interest ahead of the plan sponsor’s is a violation of ERISA, or a fiduciary breach.

What is a plan sponsor to do when the plan document clearly states that forfeitures may be used to offset plan administrative expenses or to reduce employer contributions? Here are a few recommended best practices:

• Review the forfeiture balance in the plan at least annually

• Review and discuss the applicable forfeiture provisions in the plan’s legal document in the plan committee meetings

• Keep settlor decisions and fiduciary decisions separate

• Document only the fiduciary decisions in the meeting minutes

• If the plan allows forfeitures to both offset fees and reduce employer contributions, consider establishing a written policy that states that forfeitures will be used to offset plan expenses first, and only if there are no remaining expenses that can be paid, then the forfeitures may reduce employer contributions

If there is an officer of the plan sponsor that also sits on the plan committee, make sure that the “corporate” matters are kept distinctly separate from the committee meeting. If the company would like to use the forfeiture balance to reduce employer contributions, have an officer of the company (settlor) that is not on the plan committee make a recommendation to the committee to do so. The plan committee (fiduciary) can discuss the recommendation in a meeting, make a decision that is in the best interest of the participants and can document in the meeting minutes whether the recommendation was approved or not, and why.

Until the courts provide a judgement or the IRS and DOL issue clear guidance, your best defense against forfeiture litigation is to have a good offense in place. Keep in mind that the only forfeiture litigation that has been settled thus far in favor of the plaintiffs has been related to the improper usage of forfeitures, where the plan document only permitted forfeitures to be used to offset plan expenses but were used to reduce employer contributions (in contradiction to the terms of the plan document).

Conclusion

The ongoing discussions around 401(k) plan forfeitures and ERISA litigation reflect broader trends in the workplace regarding fairness, transparency, and employee rights. As more cases arise and legal interpretations evolve, employers must stay informed to navigate the complexities of retirement plan governance effectively. A proactive approach to plan management will not only mitigate legal risks but also foster trust and loyalty among employees, ultimately benefiting all parties involved.

Newfront Retirement Services actively guides plan sponsors through these difficult subjects and keeps abreast of litigation so that you don’t have to. Feel free to contact me or just connect to keep up to date on all things ERISA and 401(k): Joni_LinkedIn

Helpful Links:

• DOL: Understanding Retirement Fees and Expenses

• Retirement topics - Vesting

• IRS: Proposed forfeiture regulations

• 401(k)ology – Plan Governance: Plan Sponsor vs. Fiduciary and Committee Roles and Responsibilities

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