401(k) Forfeitures: How and When They Must Be Used

The Internal Revenue Service (IRS) recently announced proposed regulations that affect 401(k) plans with employer contributions subject to vesting. The proposed regs deal with the use of forfeitures, which is the non-vested portion of a 401(k) account that employees are not entitled to upon termination of employment. While consistent with past IRS guidance, the proposed regs offer more clarity about when a 401(k) plan must use or allocate a forfeiture balance.

If your 401(k) plan has employer contributions subject to vesting, we recommend you give your forfeiture use a fresh look given the updated IRS guidance. By understanding the nature of forfeitures and how and when they should be used, you can avoid costly errors or reduce your out-of-pocket 401(k) plan costs.

What Are 401(k) Forfeitures?

Employees are only entitled to the vested portion of their 401(k) account balance when they terminate employment. The non-vested portion must be forfeited when certain events occur. Elective deferrals and most safe harbor contributions are always 100% vested. Other employer contributions, such as match or non-elective (a/k/a profit sharing) contributions, can be subject to a vesting schedule.

Vesting Schedule Basics

A vesting schedule determines when an employee is entitled to the employer contributions allocated to his or her account. The two most common vesting schedules are a six-year graded and a three-year cliff:

Vesting Schedule Example

To illustrate, assume you offer a traditional safe harbor 401(k) plan. In addition to the safe harbor non-elective contribution, you provide an additional non-elective contribution which is subject to a six year graded vesting schedule. Kelly was hired and begins participating in your plan in 2018. Here are her account balances in 2023 when she terminates employment:

When Do Forfeitures Occur?

The non-vested portion of an employee’s account balance is forfeited at the earlier of an employee:

• • Receiving a distribution from the 401(k) plan; or
  • Failing to work at least 500 hours for five consecutive plan years.

In our illustration, Kelly terminated employment in 2023. If she requests a distribution in 2023, Kelly’s non-vested portion of her non-elective contribution balance, $11,400 (57,000 x 20%), will be forfeited. The vested portion if her account balances, $110,100 (48,000 + 16,500 + 45,600) are distributed to Kelly according to her distribution request.

On the other hand, if Kelly does not request a distribution in 2023, no forfeiture occurs. Termination of employment only results in forfeiture if the employee is 0% vested in an account balance. Kelly’s non-vested portion will be forfeited when five years have passed (after 2028) unless she requests a distribution beforehand.

How Can Forfeitures Be Used?

Forfeitures cannot be returned to the employer. They must be used for one of the following 401(k) plan purposes:

• • Reduce employer contributions;
  • Pay reasonable plan expenses; or
  • Allocate as an additional employer contribution.

Forfeitures can be used for one or a combination of the above purposes. Verify with your plan document, but an employer most likely has the flexibility to use forfeitures in different ways either in the same year or for different years. For example, you can use forfeitures to reduce employer contributions and pay plan expenses in the same year. In addition, you can use forfeitures to reduce contributions one year and then use them to pay expenses the next year.

Back to our illustration, if Kelly requested a distribution in 2023, then your plan has $11,400 in forfeitures for 2023. Depending upon your plan document, you may have the flexibility to use those forfeitures in a number of ways.

For example, in early 2024, you may be making a safe harbor non-elective contribution of $40,000 for the 2023 plan year. You may use the $11,400 in forfeitures to reduce that employer contribution. Therefore, only $28,600 (40,000 – 11,400) needs to be paid “out-of-pocket” by you for the 2023 safe harbor contribution.

As another example, you may receive an invoice for $5,000 from your service provider in early 2024. You can use forfeitures to pay that plan expense, then use the remaining forfeiture amount (11,400 – 5,000) to either reduce employer contributions or allocate as an additional employer contribution.

Is There a Deadline For Using Forfeitures?

Most 401(k) plan documents require forfeitures to be used no later than the end of the plan year following the plan year during which the forfeiture occurred. In their proposed regulation, the IRS confirmed this deadline is the requirement.

Using our illustration again, Kelly’s forfeiture of $11,400 occurred in 2023, because that is when she requested a distribution. You should have until the end of 2024 to use that forfeiture, but some plan documents require forfeitures to be used by the end of the plan year during which the forfeiture occurred. Contact your plan provider if you are unsure of your plan’s requirement.

Assume you had several former employees who, like Kelly, all decided to request distributions in 2023 with non-vested account balances. The total forfeitures occurring in 2023 totaled $51,000. That amount is sufficient to fund the full safe harbor contribution ($40,000) and the service provider fee ($5,000) with money left over. Now what?

The remaining $6,000 can be used to pay any additional service provider fees received in 2024 or offset an additional non-elective contribution. If no other fees are received and you don’t plan on making any further contributions, the remaining $6,000 must be allocated as an additional employer contribution before the end of 2024. It is critical to use all forfeitures by the deadline to avoid an operational failure.

What Happens If I Don’t Use Forfeitures Timely?

Not using all forfeitures by the applicable deadline is an operational failure, because you are failing to operate the plan in accordance with its document. Common reasons for forfeiture build-ups are a high number of employees with non-vested account balances taking a distribution in the same year (see example above). It may also be caused by old forfeitures that are not being monitored and no direction is requested or received on how to handle.

Whatever the reason for the build-up, not timely using forfeitures is an error that needs to be corrected. The correction can be costly as forfeitures would need to be allocated as employer contributions for past years. This allocation requires census and compensation data for those past years as well as verifying if any employees have subsequently left. The time and effort required for this correction can be avoided with timely use of forfeitures.

Helpful IRS Transition Period

The IRS understands that administering a 401(k) is complex and certain tasks, such as using forfeitures, can be easily forgotten. Therefore, the IRS announced a transition period to assist employers who have a build-up of forfeitures.

The IRS will treat forfeitures incurred during any plan year beginning before January 1, 2024, as having been incurred in the first plan year beginning on or after January 1, 2024. This transition period applies regardless of the reason for the forfeiture build-up or how long forfeitures were not timely used. You should work with your service provider to determine if there is any forfeiture build-up in your 401(k) plan.

You can then properly use this build-up of forfeitures as if they occurred in 2024. The deadline for using forfeitures is no later than 12 months after the end of that first plan year (December 31, 2025 for calendar plan years). You should work with your service provider to make sure any forfeiture build-up is used before the end of the 2025 plan year.

Forfeiture Process Is a Critical Part of Plan Administration

Forfeitures can be an easily forgotten part of operating a 401(k) plan. However, monitoring and using forfeitures are critical steps in plan administration. The forfeiture process should be part of an annual administration checklist you use with your 401(k) plan. This process may be beneficial to your small business as using forfeitures can actually reduce your out-of-pocket plan costs.

If you did forget about the forfeiture process, the IRS provides a helping hand with the transition period. Make sure you determine if you need to take advantage and then use the information above to stay on track with the forfeiture process.