When an employee terminates and exits his company’s qualified retirement plan, he doesn’t only take what he saved in his account. However much he has vested of his employers’ contributions goes along, too. Sometimes, though, that amount gets calculated incorrectly.

When a plan sponsor discovers such an error, what should it do? And what are the basic Internal Revenue Service (IRS) rules about vesting that plan sponsors should follow and account for in their plan documents?

The IRS has approved two methods by which a participant becomes vested in the contributions his employer makes to his retirement account. With the simpler, cliff vesting schedule, the participant becomes 100% entitled to all company stock, match amounts, profit-sharing payments, etc., he has accumulated, on completion of, at maximum, five years of service (three years for contributions made as of 2007); until then, he may own none of it.

With graded vesting, the employee becomes progressively entitled to the employer-contributed assets, receiving at least 20% for three years of completed service, and 20% more for each additional year up to seven (two and six years for contributions made as of 2007). Whatever method a plan has adopted, the schedule must appear in the retirement plan document and its summary plan description (SPD).

If a retirement plan pays an ex-employee less than its vesting schedule required, it could lose its qualified status.

If a plan sponsor discovers this type of error and corrects it in less than two years starting from the end of the plan year in which the forfeiture occurred, use of the IRS’ Self-Correction Program (SCP) should suffice. If additional time goes by or is required, the sponsor needs to contact the IRS and—unless the failure is “insignificant”—use the Voluntary Correction Program (VCP), incurring a fee.

NEXT: What if the money was reallocated?

The IRS notes that “the forfeiture of the non-vested amount may only occur after the expiration of five years of little or no service or, if the plan provides, upon payment of the vested amount if a provision is made for a future buy-back of forfeited amounts [by rehired employees]. Forfeitures can be allocated to the remaining participants based on a pre-chosen formula or used to reduce future plan contributions.”

When a plan follows the latter practice, and forfeited savings have yet to be reallocated, it can restore the additional amount to the ex-employee's account, making adjustments for earnings, and send him a check.

More complicated is when the plan allocates the money among other participant accounts. Such plans have two IRS-approved correction options.

In the first, the “contribution correction method,” the sponsor contributes the balance of the correct distribution, adjusted for earnings, to the individual’s account. He is then issued a distribution for the account balance. If the incorrectly forfeited amount was distributed among the remaining participants, no restitution must be made—their accounts will keep the money. In the “reallocation correction method,” the money is withdrawn from the other accounts. The sponsor unallocates the amount wrongly forfeited, restoring it to the ex-employee's account, and makes a contribution to adjust for earnings. He is then issued a distribution of his restored account balance.

The key to preventing this error is to keep accurate service records for all employees, including their hours worked in a plan year, their date of hire and date of termination. The plan sponsor should also be familiar with the vesting schedule the plan has adopted so it can ensure that the proper percentage gets applied when an employee leaves the company and plan.