Administering Retirement Plan Account Forfeitures

The most common time a forfeiture occurs is when a plan participant terminates employment and is not 100% vested in the portion of his account attributable to employer contributions. Forfeitures may also occur due to failed nondiscrimination testing, participants exceeding statutory deferral limits, or when a participant with a balance left in the plan cannot be found, Robert Richter, vice president at SunGard Relius in Jacksonville Florida, tells PLANSPONSOR.

Richter explains that if a plan fails the nondiscrimination testing, and the plan dictates that excess deferral amounts for highly compensated participants must be distributed, the matching contributions related to those deferrals must also be distributed. If the participant receiving the distribution is not 100% vested in matching contributions, the vested portion is paid to the participant, while the non-vested portion is forfeited. The same is true if a participant defers more than the statutory deferral limit for the calendar year.

In the case of missing participants, the Internal Revenue Service (IRS) allows plan sponsors to forfeit their account balances at the time of a distributable event as defined by the plan document (for example, the participant reaches age 59½), Richter says. There is no specified time plan sponsors must wait before they do this, but plan sponsors must show they have done the proper due diligence to try to find the participant. If the participant is found, the plan sponsor must restore the account balance.

According to Richter, most plans provide that forfeiture occurs at earlier of plan distribution or five one-year breaks in service (BIS) for accounts that cannot be automatically cashed out (less than $1,000 or less than $5,000 if rolled into a safe harbor IRA [individual retirement account]). Richter explains the reason for the five-BIS rule, is that after those five breaks, if an employee is rehired, he will have to start over with vesting in a new account. That is, his new years of service will not add to the vested percentage of the old account balance.

He notes that a terminated participant who leaves his money in the plan, may have the non-vested portion of his account forfeited after five one-year breaks in service. The rule also means, if an employee terminates and receives a distribution from his account—with the non-vested portion of his account forfeited—then is rehired before five one-year breaks in service, he can “buy back” his forfeited account balance by restoring the amount that was distributed to him.

There are several ways a plan can allow forfeitures to be used. Richter says one common way plan sponsors use forfeitures is to pay plan expenses. He points out that they must be used for legitimate plan expenses that benefit participants. For example, a plan sponsor may use forfeited amounts to pay for Form 5500 filing with the IRS to keep the plan in compliance; a plan sponsor may not use forfeited amounts to correct for its own fiduciary breach to the plan (i.e., if the plan sponsors failed to enroll a participant when the participant was eligible, it may not use the money forfeited from others’ accounts to restore the participant to the correct account balance). Forfeitures may be used to reinstate account balances of participants who previously had their non-vested amounts forfeited and were rehired, or found.

Forfeited amounts may also be allocated to participants. The allocation of forfeitures must be nondiscriminatory; allocating to participants proportionate to compensation is a safe harbor allocation formula, Richter points out. He notes that if a plan uses permitted disparity for allocating contributions (a formula allocating additional amounts to participants earning above the Social Security taxable wage base), this formula may not be used again for allocating forfeitures. Plan sponsors should keep that in mind if their plan documents specify that forfeitures are reallocated in the same manner as employer contributions.

Richter also suggests employers design their plans so participants who terminate employment and cash out will not share in the allocation of their own forfeitures at the end of the plan year. He notes that the IRS allows for forfeitures to be used in the plan year following the year the forfeiture occurred.

Forfeitures may be added to, and allocated as, employer discretionary or non-discretionary profit sharing or match contributions. Richter points out if forfeitures are reallocated as match, they are tested as match at the time of reallocation. He warns not to allocate profit-sharing contributions based on compensation to only those who defer; only match contributions may be conditioned on deferrals.

All reallocated forfeitures, whether allocated as contributions or separately, are annual additions under Internal Revenue Code (IRC) §415 and subject to 415 limits, Richter points out.

Forfeitures may also be used to fund contributions, matching or profit sharing. Once employer contribution amounts are calculated, forfeitures may be used to offset the amount plan sponsors must pay into the plan for the contributions.

According to Richter, the IRS made a technical change that plan sponsors need to keep in mind when restating their plans in the next two years. The agency has restricted the use of forfeitures to reduce contributions. A safe harbor plan must make a 3% qualified non-elective contribution (QNEC) to participants or make a minimum match contribution, either fully vested at the time of contribution. Richter says, basically, the IRS’ thought is since forfeitures came from non-fully vested accounts, they may not be applied to these fully vested accounts. (The IRS has since issued a rule that clarifies that forfeitures may be used for QNEC and qualified matching contributions (QMACs))

Richter says one of the biggest compliance problems with forfeitures is not disposing of them timely. Typically, plan sponsors do not forfeit accounts until plan year end, and they use the money right away, but some park the money in a safe investment or trustee-directed account, he notes. A lot of employers hold onto these suspense accounts for years, but the IRS’ position is a plan cannot have unallocated accounts. The agency offers a little wiggle room, allowing forfeitures to be used in the plan year following the year the forfeiture occurred.

Common causes for improperly holding onto forfeitures include the failure to monitor suspense accounts; plan sponsors erroneously thinking they have discretion over how and when forfeitures can be applied; and plan documents being vague in describing how forfeitures are to be handled.

If employers do not dispose of forfeitures timely, and haven’t been following the terms of their plan documents, they can correct under the IRS’ Employee Plans Compliance Resolution System (EPCRS), Richter says. However, there is no prescribed method for correcting, and self-correcting usually means putting participant accounts to the position they would have been if the error had not occurred. This could be a nightmare to calculate, as it would include determining what participants in the years past would have gotten in forfeitures, the earnings they would have earned, and how to correct balances and distributions of those who had been paid out during the time period.

“Plan sponsors need to understand once they have forfeited amounts, they need to dispose of them,” Richter concludes.