Employee Benefit Plan Hot Topic: Forfeitures
Vesting in employee benefits is an immediate right to a future asset. The vested right is a promise granted to employees in a pension or retirement plan at a future date. Forfeiture of those vested rights can occur if an employee does not complete the specified service period. The use and allocation of forfeitures can be complicated and is one of the areas that the IRS monitors, so much so that the incorrect monitoring or use of the forfeitures could affect the tax-qualification of your Plan.
What are forfeitures?
Many plans offer matching and/or profit sharing contributions as part of their 401(k) plans. Associated with these contributions is a vesting schedule defined by the Plan document detailing a participant’s incremental ownership percentage of the employer’s contributions. When a participant becomes vested in a percentage of the company’s contribution, these amounts can no longer be forfeited. The vesting schedule cannot delay 100% ownership in the employer’s contributions beyond six years.
Should the employee be terminated prior to becoming 100% vested, he or she is entitled only to the amount that is vested. Upon taking a distribution, the amounts that are not vested are forfeited to the plan.
When to use the forfeiture amount?
According to the IRS, forfeitures should be disposed of on a timely basis, usually during the plan year in which they arise. Revenue Ruling 80-155 states, “A contribution plan will not be qualified unless all funds are allocated to participants’ accounts in accordance with a definite formula defined in the Plan. This would preclude a plan from carrying over plan forfeitures to a subsequent plan years, as doing so would defy the rule requiring all monies in a defined contribution plan to be allocated annually to plan participants.”
How can forfeitures be used?
If your plan accumulates forfeitures in the current year, the Plan sponsor can use these funds to reduce the Company’s expenses to the Plan by:
- Reducing employer contributions
- Paying administrative or audit fees
- Restoring previously forfeited accounts
The Plan document should be the governing item used to understand how and when the forfeitures can be used in accordance with IRS Revenue Ruling 80-155.
How to avoid the mistake
The monitoring of forfeitures by the Company and third party administrator’s is the number one prevention tool to limit failures in the allocation and use of forfeitures. If your Plan uses a suspense account, ensure that forfeitures are properly being applied in connection with Revenue Ruling 80-155 and your Plan document. Remember these suggestions when monitoring the use of your forfeitures:
- Forfeitures should not remain in your suspense account past the year in which they occurred.
- If using the forfeitures for Plan expenses or employer contributions, be sure to do so in accordance with the language in your Plan document
While forfeitures may seem tricky, monitoring them on a regular basis will help ensure that the Plan is using them correctly while positively affecting the cash-flow of the Company by reducing employer contributions or paying plan expenses. Reaching out to your third party administrator, Clayton & McKervey, P.C., or your ERISA counsel could be beneficial should you have any questions relating to forfeitures.
Fixing the problem
Should you find your plan operating outside of the requirements, there are ways to fix the problem. Depending on the Plan and the operational defect, the problem could be corrected by allocating forfeitures in the plan’s suspense account to participants who should have received them in previous years. This may result in distributions to participants who have already left the company and received their cash payout.
If corrected within two years of the error, the Company can use procedures in the Revenue Procedure 2008-50.6. and the Employee Plans Compliance Resolution System (EPCRS) which allow self correction. If the failure is a result of an error that occurred more than two years prior, the Company should use the Voluntary Correction Program (VCP). The VCP may also be used should the terms of your Plan document need to be retroactively corrected by a Plan amendment. Clayton & McKervey, P.C. would recommend speaking with your ERISA counsel when determining how to fix the problem to ensure that the problem has been mitigated and does not affect the tax-qualification of your Plan.