401(k) plans that include employer contributions with vesting schedules will inevitably accumulate forfeitures. Plan sponsors must decide how to allocate these funds, but failure to use them properly can result in compliance issues. Here are the details.

Quick Takeaways

• Forfeitures occur when employees leave before full vesting in employer contributions.
• These funds must be used properly, per IRS rules and your plan document to avoid compliance risks.
• Forfeitures can be used to offset employer contributions, pay plan expenses, and reinstate balances for rehired employees.
• Mismanagement or delay in using forfeitures can lead to penalties or plan disqualification.
• Recent ERISA lawsuits have put fiduciary practices around forfeitures under scrutiny—document your decisions carefully.

What Are 401(k) Forfeitures?

When an employee leaves a company before they are fully vested in their employer’s contributions, the unvested money goes into a separate forfeiture account. Employer contributions are a common benefit to the plan when it is forfeited by an employee. These funds have to be used according to the plan document, but many Plan Administrators don’t always handle them correctly. This can lead to compliance problems and financial risks.

How Can Forfeitures Be Used?

The IRS allows plan sponsors to use forfeitures in the following ways:

• Pay administrative expenses – Forfeitures can cover plan-related fees and costs.
• Reduce employer contributions – Employers can use forfeitures to offset matching, profit-sharing, or safe harbor contributions.
• Restore previously forfeited balances – If a former employee is rehired, forfeitures may be used to reinstate their account balance.
• Reallocate as additional employer contributions – Plans may distribute forfeitures as discretionary contributions, subject to annual contribution limits.
• Offset QNEC/QMAC contributions – Forfeitures can reduce required qualified non-elective and matching contributions for testing compliance.

What to Avoid

Forfeitures must be used in accordance with the plan document. In addition, forfeitures should be used within a specific timeframe to maintain the plan’s tax-qualified status. Most plan documents require forfeitures to be used by the end of the plan year in which they arise or the following year. The IRS recently proposed a 12-month limit for using forfeitures, with a transition rule allowing prior accumulated forfeitures to be used by December 31, 2025. Allowing forfeitures to accumulate beyond these deadlines could result in compliance failures.

Best Practices for Plan Sponsors

Recent ERISA litigation has focused on whether using forfeitures to reduce employer contributions benefits the employer more than plan participants. To mitigate risk, plan sponsors should:

• Only document fiduciary decisions in meeting minutes. Focus on clearly stating the final decision reached by the fiduciaries.
• Consider a written forfeiture policy, prioritizing forfeitures for plan expenses before reducing employer contributions, if the plan allows for forfeitures to both reduce employer contributions and offset fees.
• Confirm the plan document’s forfeiture provisions and discuss them in plan committee meetings and document these discussions within meeting minutes.
• Distinguish between Plan Sponsor/Employer and fiduciary decisions, keeping business and fiduciary matters separate.
• Review the forfeiture balance annually to ensure timely use.

While IRS rules govern forfeiture usage, recent ERISA lawsuits suggest that plan fiduciaries must also consider participant interests. By following best practices and ensuring compliance with plan terms, plan sponsors can reduce legal risk while effectively managing forfeitures. Now is the time to review your plan’s forfeiture account. 

If you have questions about your plan’s forfeiture use, connect with us, we’re here to help. Fill out the form below to get the conversation started.