Fun with Forfeitures
June 2016 Newsletter
Sooner or later, almost all 401(k) plans will face the
"fun" of dealing with forfeitures. Just like every other plan-related
operational item, there are specific rules that provide guidance on the "who,
what, why, when and where" of using forfeitures.
What is a forfeiture?
Putting it simply, a forfeiture is the non-vested portion of a participant's
account that he or she gives up in certain instances. The most common trigger is
when a partially vested participant terminates employment and takes a
distribution. That participant receives the vested portion and forfeits the
Certain discrimination testing failures can also generate forfeitures by
highly compensated employees (HCEs). For example, if a plan fails the average
contribution percentage (ACP) test, amounts that are outside the limits are
often distributed from the plan to the affected HCEs. However, if a particular
HCE is not fully vested, he or she receives only the vested portion of the
excess amount with the remainder treated as a forfeiture.
What isn't a forfeiture?
This is probably a good place to touch on amounts that may appear similar but
are not actually forfeitures. Here are several:
- Revenue sharing held in an ERISA spending account;
- Pre-funded company contributions that have not yet been allocated to
- Removal of company contributions allocated to a participant by mistake;
- Settlement proceeds from mutual fund litigation; and
- Amounts that exceed other plan or regulatory limits.
Although these might look and feel like forfeitures, there are different sets
of rules that determine when and how these amounts can/must be used. That means
properly identifying and tracking them is critical to ensuring operational
When do forfeitures occur?
Now that we've addressed the "what," it's time to talk about the "when." The
answer to this question can be found in the plan document, and it is usually a
function of how long a participant has been gone and when he or she takes a
distribution. This is important because knowing when forfeitures occur is
critical to determining when they can/must be used.
One of the more common plan document provisions is that a forfeiture occurs
on the earlier of the date the participant:
- Receives a complete distribution of his or her vested account balance,
- Incurs five consecutive one-year breaks in service.
Let's look at both in turn.
When is a distribution "complete"?
A complete distribution is pretty straightforward, but there is one nuance to
check. Many plans include a provision that says if a participant terminates
without any vested balance, he or she is treated as if a complete distribution
When applying this rule, keep in mind that it doesn't just refer to amounts
that are subject to a vesting schedule, like matching or profit sharing
contributions. It also includes fully vested accounts like 401(k) deferrals and
rollovers. In other words, the participant in question must be 0% vested and not
have any deferrals in his or her account.
This rule often dovetails nicely with mandatory distribution provisions
included in many plans, which require distributions to former employees when
they have vested account balances of less than $5,000.
What is a one-year break in service?
Turning our attention to the second of the conditions, a one-year break in
service (also referred to simply as a break in service) occurs on the last day
of a plan year in which the former employee works fewer than 501 hours. This may
be more easily explained with an example.
Emmett works 750 hours during 2016 before terminating
employment in May of that year. Emmett's first break in service will not occur
until December 31, 2017. Assuming Emmett is not rehired, his fifth consecutive
break in service will not occur until December 31, 2021.
These rules are fairly common, but be sure you confirm your specific plan's
provisions. Some plans say that forfeitures occur on the later of these two
conditions (rather than the earlier of…big difference). Other plans use a single
break in service rather than five of them. Still other plans use a number less
than 501 hours to define a break in service.
How are forfeitures used?
So, you have this pot of stray money that needs to be used. What can you do
with it? It might seem reasonable to think you can pull it out of the plan and
use it for something unrelated, but that is a big "NO-NO." You generally have
three options. You can use forfeitures to:
- Pay allowable plan expenses;
- Reduce employer contributions (other than safe harbor contributions,
Qualified Nonelective Contributions (QNECs) or Qualified Matching
Contributions (QMACs)); and/or
- Add to employer contributions.
Most plan documents include language authorizing any of these uses; however,
some limit use to only one or two of these options.
IRS and DOL rules limit the types of expenses that are allowed to be paid
using plan assets. Since forfeitures are still assets that belong to the plan,
they can only be used to cover expenses the plan is otherwise allowed to pay.
The other two options, reducing or adding to company contributions, seem
fairly similar, and are better explained with an example.
The ABC Company 401(k) Plan has a forfeiture account
balance of $2,000. ABC decides to make a profit sharing contribution of 5% of
compensation for the year, which equals $20,000. In this case, ABC could remit
$18,000 and use the $2,000 in forfeitures to bring the total to $20,000. This is
an example of using forfeitures to reduce the contribution.
Alternatively, assume ABC wishes to deduct a
contribution of $20,000 on its corporate tax return, so it remits $20,000 to the
plan and adds the $2,000 in forfeitures for a total allocation to employees of
$22,000. Since the forfeited amounts were deducted when they were originally
contributed (before they were eventually forfeited), they are not deducted a
second time when allocated from the forfeiture account. This is an example of
adding forfeitures to the contribution.
It is important to remember that IRS regulations limit the types of
contributions that can be funded with forfeitures. Those rules require safe
harbor matching and nonelective contributions to be fully vested when they are
contributed to the plan. Since forfeitures arise from non-vested account
balances, they could not have been fully vested at the time of initial
contribution, so they cannot be used to fund these types of contributions. The
same is true for other types of QNECs and QMACs.
Can forfeitures be reinstated?
There is one other option available for using forfeitures even though it does
not arise all that often. It's not all that uncommon for a former employee to be
rehired, but it is quite uncommon for that rehired person to pay back a
distribution he or she took from the plan when he or she terminated the first
If you experience this rare occurrence, the employee in question may be
entitled to have any previously forfeited amounts reinstated to his or her
account, and money in the forfeiture account can be used to fund that
When must forfeitures be used?
Contrary to popular belief, forfeitures cannot sit there and accumulate over
time. Rather, IRS rules and plan document provisions dictate when they must be
used. Typically, that timing is either by:
- The end of the plan year in which they occur, or
- The end of the plan year following the year in which they occur.
Some plans are written more broadly to say forfeitures must be used no later
than the end of the year after the year of occurrence, which effectively offers
flexibility over two plan years. However, since we're talking about when they
must be used rather than when they can be used, it is important that you know
exactly what your plan requires.
Let's return to our friends at ABC Company for a few examples to clarify
Assume the forfeitures were generated in 2015. The plan requires that they be
used in the year of occurrence. If ABC doesn't have any remaining expenses to
pay for 2015, the forfeitures must be used toward company contributions for
2015. They cannot be carried forward and applied to 2016. If ABC doesn't
normally make profit sharing contributions, it could declare a $2,000 match so
that it is allocated only to participants who otherwise have an account balance
in the plan.
Assume, instead, ABC's plan requires forfeitures to be used in the year
following occurrence, and there are unpaid fees for 2015. The $2,000 could not
be used to pay those expenses but would need to be held and used for 2016
expenses or contributions.
If the plan uses the more flexible "no later than" language, the $2,000 could
be used for either 2015 or 2016.
What can I do to get this right?
Proper treatment of forfeitures is something that is on the IRS's radar, and
some proactive planning can go a long way. For starters, make sure you know what
your plan says and then monitor your forfeiture account on an ongoing basis.
This allows you the greatest time frame to use those forfeitures in a way that
works well for the plan and the participants.
It's also a good idea to review your plan design to see if you can build in
features that give you more flexibility. For example, if you have a safe harbor
401(k) plan, make sure it also allows for an additional discretionary matching
contribution. Since allocation of forfeitures to key employees (generally owners
and officers) can trigger required "top heavy" contributions, perhaps writing
the plan to place each participant in a separate profit sharing allocation group
would allow you to make sure contributions only go to non-key employees.
Despite the title of this article, dealing with forfeitures is never really
fun, but working with experienced professionals can help ensure smooth sailing.
This newsletter is intended to provide general
information on matters of interest in the area of qualified retirement plans and
is distributed with the understanding that the publisher and distributor are not
rendering legal, tax or other professional advice. Readers should not act or
rely on any information in this newsletter without first seeking the advice of
an independent tax advisor such as an attorney or CPA.