Recent developments spotlight issues with forfeiture and other unallocated accounts in defined contribution retirement plans, such as 401(k) plans:
- The IRS has set the deadline for plan forfeiture use.
- Participants in retirement plans have brought legal challenges to plan sponsors exercising discretion to use forfeitures to reduce employer contributions.
- Some plan providers are improperly mixing forfeitures with other unallocated funds.
Forfeitures Deadline and Grace Period
New Deadline
Traditionally, retirement plans could use forfeitures to either fund employer contributions or pay plan expenses. However, prior to recent proposed regulations from the IRS, the timing for when defined contribution plans must use forfeitures had been murky; the IRS took the position in a spring 2010 newsletter that forfeited amounts could not accumulate over several years in a suspense account.
Proposed regulations clarify that defined contribution plans must use forfeitures no later than 12 months following the end of the plan year in which the forfeiture occurred. The new deadline takes effect for plan years beginning on or after January 1, 2024.
Example: A 401(k) plan operates with a calendar year plan year. On November 2, 2024, an employee terminates and forfeits $1,000 in unvested contributions. Under the new deadline, the plan has until December 31, 2025, (12 months following the end of the plan year in which the forfeiture occurred) to use the $1,000 in forfeitures.
Grace Period
The proposed regulations also provide a “grace period” for acclimating to the new deadline. Defined contribution plans must use all pre-2024 forfeitures no later than 12 months after the end of the first plan year beginning on or after January 1, 2024. For most plans, this date is December 31, 2025.
Example: A 401(k) plan operates with a calendar year plan year. Between 2021 and 2023, the plan accumulated $26,000 in forfeitures. As of January 1, 2024, the plan had not used any of the $26,000 in accumulated forfeitures. Under the IRS grace period, the plan has until December 31, 2025 (12 months following the end of the plan year beginning on January 1, 2024), to use the $26,000 in forfeitures.
Reviewing Your Plan Document – When and How to use Forfeitures
Plan sponsors should evaluate when their plan documents and internal procedures permit the use of forfeitures.
Plans that traditionally use all forfeitures by the end of the plan year in which they occurred may benefit from the leniency of the new rule, which allows forfeitures to “rollover” to the next plan year. This may require amending the plan document to permit holding forfeitures for the entire length of time until the new IRS deadline.
Plans that previously held forfeitures for longer than the following plan year should revise their practices to comply with the new IRS deadline. This may require amending the plan document to prevent forfeitures from carrying forward further than the plan year following the plan year in which the forfeitures occurred. Plans that have accumulated forfeitures from several years may also need to be amended to allow the use of the forfeitures during the IRS grace period.
Critically, plan sponsors should also take this opportunity to review how their plan document permits them to use forfeitures. Although the IRS currently permits sponsors to use forfeitures for several purposes, plans are still limited by what is permitted under the plan document. Using forfeitures for a purpose not permitted in the plan document will require an amendment and perhaps a correction under IRS or DOL correction procedures.
Using Forfeitures for Employer Contributions = A Fiduciary Breach?
Some plan participants are litigating the use of forfeitures to reduce employer contributions, despite the IRS having accepted this practice for decades both in plan documents and on review in audits. In several complaints against large employers — including Qualcomm, HP, Intuit, Clorox and Thermo Fisher — plaintiffs allege that the employers (and their retirement plan committees) abused their fiduciary discretion when choosing to use forfeitures to reduce employer contributions rather than to pay plan expenses.
In each of these cases, the plan documents authorized the plans to use forfeitures to reduce employer contributions; however, the plaintiffs allege that it is a breach of fiduciary duty if the fiduciary exercises discretion to use forfeitures to reduce the employer’s contributions if it could use the forfeitures to lower participants’ expenses instead. In response, the defendants have argued that not every decision by a plan administrator is a fiduciary one and that ERISA doesn’t require employers to provide specific levels of benefits (for example, benefit-level decisions are plan design decisions rather than fiduciary decisions).
In recent months, two federal courts in California have reached opposite conclusions on this issue. In Perez-Cruet v. Qualcomm Incorporated, the United States District Court for the Southern District of California denied the defendant’s motion to dismiss, holding that the company’s exercise of discretion to use forfeitures to reduce company contributions instead of paying plan expenses presented a colorable claim under ERISA. In Hutchins v. HP Inc., the United States District Court for the Northern District of California granted the defendant’s motion to dismiss on nearly identical facts and legal issues. The defendant in Qualcomm has already filed a motion to reconsider the ruling in that case in light of the HP decision.
Fiduciaries and employer sponsors should monitor these cases as they progress and may want to take action regarding their plan language and use of forfeitures as discussed below.
Forfeitures v. Other Unallocated Accounts
IRS rules allowing plans to apply forfeitures to reduce employer contributions do not apply to other unallocated accounts. Plans may not use other unallocated plan accounts, such as suspense account funds or ERISA spending accounts funds, to reduce employer contributions.
While reviewing plan documents for compliance with the new IRS deadline and grace period, plan sponsors should also review their recordkeeping processes for non-forfeiture unallocated plan accounts. In practice, a plan recordkeeper may use a single account to hold multiple forms of unallocated plan assets — whether from forfeitures, suspense account funds or ERISA spending account funds. However, these different forms of unallocated plan assets each have different permitted uses, and plan sponsors may not use them interchangeably.
Plan recordkeepers should keep forfeitures separate from suspense, ERISA and similar accounts at all times. If this is not possible, plan recordkeepers should maintain thorough records that distinguish the sources of funds in a single account.
Key Takeaways for Plan Sponsors
- Review your plan document and ensure that:
- Your plan permits your current forfeiture practices and procedures. If not, you will need to make a plan correction.
- Your plan’s deadline for using forfeitures is not earlier or later than the new IRS forfeitures deadline. If the plan deadline is earlier than the IRS deadline, an amendment will provide you with more flexibility to use your forfeitures. If the plan deadline is later, an amendment is needed to comply with IRS requirements.
- Your plan allows you to use the IRS grace period, if needed. You may need to amend your plan to permit the use of accumulated forfeitures during the grace period.
- Maintain your forfeiture account separate from other unallocated accounts.
- Keep sufficient records to show how and when you use forfeitures and other unallocated accounts.
- If your plan provides discretion to apply forfeitures to pay expenses or reduce employer contributions, consider whether an amendment would be appropriate. If in practice you are consistently applying forfeitures using the same method each year, then we recommend amending your plan to eliminate that discretion.
