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Managing forfeitures of unvested 401(k) funds

By Edwin Zalewski, SHRM-CP, PHR

Many employers offering defined contribution plans such as 401(k) plans will provide matching fund or other employer contributions. Generally, employees must complete a period of service (such as seven years) before becoming fully vested in the employer contributions. If an employee leaves a company before becoming fully vested, his or her non-vested account funds may be forfeited.

Employers then face the question of what to do with those funds. Can the employer take back that money? Can the employer place the funds in an account for use in future years? The Internal Revenue Code does not allow either option. Forfeitures must be used or allocated in the same plan year. Federal law does not allow accounts of unallocated money beyond the current plan year.

According to the Internal Revenue Service (IRS), a defined contribution plan will not qualify for income tax deferral status unless all funds are allocated to participants’ accounts according to a formula defined in the plan. A disqualification of the plan could have tax consequences for all participants.

Allocating funds
Forfeited funds may be used to pay a plan’s administrative expenses and/or to reduce employer contributions (e.g., the funds may be reallocated as matching contributions for other employees). The IRS regulations indicate that forfeitures must be used as soon as possible to reduce employer contributions.

The plan’s terms should include provisions detailing how and when a plan will use forfeited funds. A failure to use the funds in a timely manner may cause the participating employees to miss out on additional benefits or incur additional plan expenses.
  Problems with forfeited non-vested funds may arise when:

• The plan sponsor or third party administrator fails to monitor the account to ensure that forfeitures generated in that plan year are used according to the plan’s terms.
• The plan sponsor mistakenly thinks he or she has discretion over how and when forfeiture funds can be applied.
• Plan document terms are vague in describing how forfeitures should be handled, resulting in improper operation of the plan.

Fixing errors
Generally, errors can be corrected by reallocating forfeitures to plan participants who should have received them (if the funds had been allocated on time). If the plan carried over amounts from previous years, the plan sponsor should revise prior year allocation reports to reflect the forfeiture allocation and pay any amounts due to terminated participants.

Depending on the plan terms or the facts of a particular situation, it might be appropriate to use previous-year forfeitures as employer contributions in the current year. Plan sponsors should apply the correction principles in Revenue Procedure 2008-50, section 6, when making such corrections.

Plan sponsors may also correct mistakes using the Employee Plans Compliance Resolution System (EPCRS). Using the Self-Correction Program, the mistake must generally be fixed within two years following the close of the plan year in which it occurred. Unless the failure can be classified as insignificant, the Voluntary Correction Program (VCP) must be used after this time. The VCP must also be used if the plan document terms are defective and need to be corrected retroactively by a plan amendment.

If a suspense account is used, the plan sponsor or third party administrator must ensure that all forfeitures are promptly used according to the plan’s terms. No forfeitures should be carried into a subsequent plan year.

For plans using forfeitures to reduce expenses or employer contributions, there should be plan language and administrative procedures to ensure that forfeitures will be used promptly in the year they occurred or (in appropriate situations) no later than the immediately succeeding plan year.