Proposed regulations on the use of forfeitures in qualified retirement plans and four best practices

Generally, the proposed regulations don’t provide a new position. Rather, they seek to formalize the informal position that the IRS had previously taken and communicated in a 2010 “Employee Plans” newsletter (Publication 4278, Rev. 5-2010), which should provide 401(k) plan sponsors with more detailed guidance for administrative and audit purposes. The applicability date of the proposed regulations is for plan years beginning on or after January 1, 2024, but plan sponsors may rely on them now. 

What are forfeitures?

Briefly, if a participant separates from service with the employer before being 100% vested in the plan, the nonvested portion of the account becomes a forfeiture based on the earlier of: 

a) Distribution of the vested account balance, or 

b) Incurring five consecutive breaks in service. 

Former participants who terminate and receive a distribution of their vested account balance and are then subsequently rehired may have the right to repay this distribution. To do so, the repayment must be within five years from the date of reemployment, or, if earlier, before the employee incurred five consecutive breaks in service (measured from the date of distribution). 

Depending on the terms of the plan document, the plan sponsor may:

• Use the forfeitures to reduce future employer contributions to the plan for the remaining participants
• Reallocate the forfeitures to the remaining eligible participants
• Use them to restore previously forfeited amounts from accounts of participants rehired before incurring five consecutive breaks in service
• Pay plan administrative expenses with the forfeitures   

Proposed forfeiture regulations for timing and usage

The proposed regulations address the timing and usage of forfeitures. While it’s not a new concept, the proposed regulations state that forfeitures must be used no later than 12 months after the close of the plan year for which the forfeitures occurred. For example, for a calendar year plan, if forfeitures occur in 2024, they must be used no later than December 31, 2025. The proposed regulations require that plan documents state how forfeitures can be used for one or more of the following purposes:

• To pay plan administrative expenses
• To reduce employer contributions 
• To increase benefits in other participants’ accounts (i.e., reallocate in accordance with plan terms)

Since the use of forfeitures must be included in the plan document, the preamble to the proposed regulations states that a plan may have an operational violation if it provides only one use for forfeitures, and the forfeitures exceed the amount that may be used for that one purpose. It provides this example:

A plan document specifies that forfeitures may be used only to pay plan expenses. The amount of forfeitures, however, exceeds the plan administrative expenses incurred before the end of the 12-month period following the end of that plan year. In this case, there may be an operational violation. 

Based on our experience, most plans generally provide more than one method to use forfeitures and often specify all three methods of usage outlined above, which is a best practice.  

The preamble also provides some clarification with respect to using forfeitures to restore inadvertent overpayments and for the restoration of conditionally forfeited participant accounts that might otherwise require additional employer contributions (which ties in nicely with overpayment recovery relief provided under Section 301 of SECURE 2.0 Act).

The transition rule for use of forfeitures

The proposed regulations also provide a key transition rule that should be beneficial to plan sponsors. This rule allows plan sponsors that haven’t used previous years’ forfeitures in a timely manner to comply with the proposed regulations. The transition rule provides that any forfeitures that were incurred in any plan year beginning before 2024 are treated as having been incurred in the first plan year that begins on or after January 1, 2024, and, thus, must be used no later than December 31, 2025, for a calendar year plan. This allows sponsors to take advantage of the transition rule to review plan forfeitures and use up any unused forfeitures incurred prior to January 1, 2024, for calendar year plans, and in the 2024 plan year by the end of December 31, 2025. This will help sponsors alleviate any operational defects or potential audit issues.

Forfeitures aren’t the same as plan expense reimbursement agreements 

There’s often confusion between forfeitures and plan expense reimbursement agreements (often referred to as PERA or ERISA budgets). To clarify, the proposed regulations don't speak to the timing or usage of amounts held in ERISA budgets. While generally outside the scope of this viewpoint, ERISA budget proceeds are excess revenue derived from the revenue sharing agreements with an administrative service provider or third-party administrator. The revenue is typically generated from the administrative fees that are charged by the mutual funds offered under the plan. In a DC plan, depending on the investments and fee structure of the participant-directed fund lineup, an ERISA budget may be created to hold and use assets to pay plan-related expenses that can properly be paid from plan assets (e.g., certain legal, accounting, and recordkeeping fees). Although the usage forfeitures and ERISA budgets may be similar in some cases, they aren’t the same and they follow different rules. Since these revenue sharing accounts come from excess revenue generated by participants, the best practice is to use the amounts in the ERISA budget by the end of the first calendar quarter following the year in which the excess was generated. Also, because these amounts inure to the  participants in the plan, they can’t be used to pay for settlor expenses (such as offsetting employer contributions).

Four best practices for retirement plan forfeitures 

Although the proposed forfeiture regulations are effective for plan years beginning on or after January 1, 2024, plan administrators may rely on them now. As a result, plan sponsors should consider the following actions:

1. Review the plan document to confirm the forfeiture usage and amend the document to expand usage, if necessary;
2. Work with your client service manager/strategic relationship manager to ensure forfeitures are used in a timely manner;
3. Take advantage of the transition period to use up any prior forfeitures incurred prior to 2024. It seems somewhat likely that the use of forfeitures will become a key audit issue going forward if the plan isn’t in compliance with the timing rules (including the transition rule) in the future; and
4. Don’t confuse the requirements for plan forfeitures with those of an ERISA budget. Assets in an ERISA budget should be used by the end of the first quarter following the year the excess revenue was accrued in order to ensure they’re benefiting the participants who generated the revenue for the applicable year.