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Forfeitures

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What Are Forfeitures?

Forfeitures in the context of retirement plans refer to the non-vested portion of employer contributions that an employee relinquishes when they leave a company before fulfilling the requirements of the vesting schedule. These funds are retained within the qualified retirement plan itself, specifically within a forfeiture account, rather than being returned directly to the employer or distributed to the departing employee. The use of these forfeited funds is strictly governed by the plan's plan document and specific guidelines set by regulatory bodies. Forfeitures are a common element in defined contribution plans, such as 401(k)s and profit-sharing plans, falling under the broader financial category of retirement plan administration.

History and Origin

The concept of forfeitures in retirement plans is closely tied to the evolution of employer-sponsored savings programs and the establishment of rules to protect plan participants. Before the advent of comprehensive legislation, employer contributions to retirement plans were not always guaranteed to employees. The passage of the Employee Retirement Income Security Act (ERISA) in 1974 marked a significant milestone, introducing standards for vesting and fiduciary conduct in private industry retirement plans. ERISA established that employer contributions, while subject to vesting, must ultimately benefit plan participants, even if an individual employee's non-vested portion is forfeited. The Internal Revenue Service (IRS) and the Department of Labor (DOL) have since provided extensive guidance on the proper handling and use of forfeitures. Recent proposed IRS regulations, for example, clarify that forfeitures incurred before January 1, 2024, are to be treated as incurred in the first plan year beginning on or after January 1, 2024, meaning they must generally be used by December 31, 2025, for calendar year plans.42,41,40

Key Takeaways

  • Forfeitures are the non-vested portion of employer contributions that employees lose upon leaving a company before fully vesting.39,38
  • These funds remain within the retirement plan and cannot be returned directly to the employer.37,36
  • Forfeitures must be used for specific purposes: to reduce future employer contributions, pay administrative expenses of the plan, or be reallocated to remaining participants' accounts.35,34,33
  • The Internal Revenue Service (IRS) sets strict deadlines for the use of forfeitures, typically within 12 months after the close of the plan year in which they were incurred.32,31,30
  • Proper management of forfeitures is crucial for a plan sponsor to maintain the qualified retirement plan's tax-advantaged status.29

Interpreting Forfeitures

Forfeitures are an inherent part of many defined contribution plans and reflect the employer's incentive structure for employee retention. A higher rate of employee turnover, particularly among newer employees, can lead to a larger pool of forfeitures. From a plan sponsor's perspective, a significant forfeiture balance can be utilized to reduce the company's future contributions to the plan or cover the plan's administrative expenses. This can indirectly benefit remaining participants by lowering overall plan costs. Conversely, if forfeitures are consistently low, it suggests stable employee tenure and potentially higher ongoing employer funding needs. The interpretation also hinges on adherence to regulatory requirements set by the Internal Revenue Service (IRS), ensuring funds are used appropriately and timely.

Hypothetical Example

Consider "Tech Innovations Inc." which offers a 401(k) plan with a four-year graded vesting schedule for its 5% matching employer contributions: 25% vested after one year, 50% after two years, 75% after three years, and 100% after four years.

An employee, Alex, has been with Tech Innovations for 2.5 years and has accumulated $8,000 in employer matching contributions. Under the graded vesting schedule, Alex is 50% vested in these contributions. If Alex decides to leave the company, the vested portion would be $8,000 * 0.50 = $4,000. The remaining $4,000 ($8,000 - $4,000) would be a forfeiture. This $4,000 would then be moved into the plan's forfeiture account to be used by the plan administrator for permissible purposes, such as reducing future matching contributions for other employees or paying plan fees.

Practical Applications

Forfeitures play a practical role in the financial management of qualified retirement plans. Primarily, they are used by plan sponsors in three main ways:

  • Offsetting Employer Contributions: A common use of forfeitures is to reduce the amount an employer needs to contribute to the plan in subsequent periods. For instance, if an employer is committed to a certain level of matching contributions, the available forfeitures can be used to meet part or all of that obligation, thus reducing the company's out-of-pocket expenses.28,27,26 This practice has been affirmed by the Department of Labor as permissible under ERISA.25,24
  • Paying Plan Administrative Expenses: Forfeitures can be utilized to cover the various administrative expenses associated with running the plan, such as record-keeping, legal fees, and auditing costs. This can benefit both the employer and participants by potentially lowering fees that might otherwise be borne by individual retirement accounts or the company directly.23,22
  • Reallocating to Participants: In some cases, and as permitted by the plan document, forfeitures can be reallocated among the remaining active participants in the plan. This can take various forms, including increasing allocations of employer contributions or being used to help satisfy non-discrimination testing requirements.21,20,19

The precise application of forfeitures depends on the specific language within a company's plan document and adherence to guidelines from the Internal Revenue Service (IRS) and the Department of Labor.

Limitations and Criticisms

While forfeitures offer flexibility for plan sponsors, their management comes with strict regulatory requirements and potential pitfalls. A primary limitation is the inability for forfeited funds to revert back to the employer; they must remain within the qualified retirement plan for the benefit of participants.18,17

A significant area of concern and the subject of recent litigation revolves around the timing and method of using forfeitures. The Internal Revenue Service (IRS) has reinforced that forfeitures must be used no later than 12 months after the close of the plan year in which they were incurred. Failure to meet this deadline can lead to operational issues that may jeopardize the plan's tax-qualified status.16,15

There have also been legal challenges alleging that using forfeitures to reduce employer contributions rather than reallocating them to participants or paying administrative expenses could violate fiduciary duties under Employee Retirement Income Security Act (ERISA). Although the Department of Labor has defended the practice of using forfeitures to offset employer contributions, stating it is permissible and has been the established understanding for decades, these lawsuits highlight the complexities and scrutiny plan sponsors face.14,13

Forfeitures vs. Vesting

Forfeitures and vesting are intrinsically linked but represent distinct concepts in retirement plans. Vesting refers to the process by which an employee gains non-forfeitable ownership of employer contributions made to their retirement accounts over time. An employee is "vested" in a portion of their employer's contributions once they meet certain service requirements specified in the vesting schedule outlined in the plan document.

Conversely, forfeitures occur when an employee leaves a company before they are fully vested in their employer's contributions. The non-vested portion of these contributions is then "forfeited" back to the plan. In essence, vesting is the earning of the right to the funds, while forfeiture is the loss of the right to the non-vested portion of those funds. Employee contributions and any investment income on those contributions are always 100% vested and cannot be forfeited.12,11

FAQs

What happens to forfeited money in a 401(k) plan?

Forfeited money in a 401(k) plan is held in a special forfeiture account within the plan itself. It cannot be returned to the employer. Instead, it must be used for specific purposes benefiting the plan, such as reducing future employer contributions, paying plan administrative expenses, or being reallocated to other participants' accounts.10,9,8

Are employee contributions subject to forfeiture?

No, employee contributions to a qualified retirement plan are always 100% vested and are never subject to forfeiture. Forfeitures only apply to the non-vested portion of employer contributions.7,6

How quickly must forfeitures be used?

The Internal Revenue Service (IRS) generally requires that forfeitures be used no later than 12 months after the close of the plan year in which they were incurred. There are specific transition rules for forfeitures incurred before 2024, which generally must be used by the end of 2025 for calendar year plans.5,4,3

Can forfeitures be used to fix plan errors?

Yes, in some instances, if permitted by the plan document, forfeitures may be used to help correct certain compliance failures or non-discrimination test failures in a qualified retirement plan.2,1