Mitigate Risk with Clear Policy on Use of Forfeitures in 401(k) Plan Provisions
Forfeitures in employee benefit plans present both opportunities and challenges for plan sponsors.
By aligning practices with IRS regulations and creating plan documents that are clear and comprehensive, sponsors can effectively manage forfeitures while mitigating legal risks.
Adopting a written policy on the use of forfeitures and staying informed about plan provisions can enhance the overall effectiveness of employee benefit plans, potentially benefiting both the organization and its participants.
Understanding Forfeitures in 401(k) Plans
Forfeitures in 401(k) plans are an important topic for plan sponsors and fiduciaries to understand, as they can significantly impact both plan management and participant benefits. It’s crucial to grasp how forfeitures can be utilized effectively and in compliance with IRS regulations.
What is a Forfeiture?
A forfeiture occurs when a participant in a 401(k) plan loses their right to all or part of the employer contribution that has been allocated to their account, typically due to not meeting specific conditions outlined in the plan document or adoption agreement.
Common scenarios that lead to forfeitures include:
- Termination of employment. If an employee leaves the company before being fully vested in the employer contribution, the unvested portion may be forfeited.
- Failure to meet service requirements. Employees may need to complete a certain number of hours worked per year. If they do not meet this requirement, they may forfeit their rights to the employer contribution allocated to their account.
- Withdrawal from the plan. If a participant withdraws from the plan before reaching the vesting schedule, any unvested employer contributions may be forfeited.
Use of Forfeitures
The plan document or adoption agreement should define how forfeitures can be used.
Generally, forfeitures can be used by plan sponsors to offset future employer contributions, pay plan administrative expenses, or be allocated to all participants within the plan, making them an essential aspect of plan management.
It’s important for forfeitures to be used timely. Most 401(k) plan documents or adoption agreements require forfeitures to be used no later than the end of the plan year following the plan year during which the forfeiture occurred, which is consistent with IRS proposed regulations on the timing of the use of forfeitures.
Trends in Lawsuits Regarding Forfeitures
While the legal landscape can change, there’s been a trend of lawsuits since 2023 focusing on how plan sponsors manage forfeitures. Plaintiffs have challenged the practices of plan sponsors who use forfeitures to reduce future employer contributions, arguing that such actions can be detrimental to plan participants.
However, the IRS allows the practice of using forfeitures for various purposes, including paying plan expenses and offsetting future employer contributions.
Generally, plaintiffs have not been successful in these lawsuits, indicating that IRS guidelines provide a solid foundation for plan sponsors to operate within.
Reviewing Plan Documents
One of the most critical steps for plan sponsors is to review their plan document and adoption agreement regarding forfeitures.
It’s essential to ensure that the language in the plan document or adoption agreement clearly outlines how forfeitures are to be handled.
Some plan documents or adoption agreements allow forfeitures to be used for multiple purposes but don’t specify the order in which forfeitures should be applied. This lack of clarity can lead to confusion and potential disputes.
Establishing a Written Policy
To mitigate risks and enhance clarity, plan sponsors should consider adopting a written policy that specifies the order in which forfeitures can be used if that order is not specified in the plan document or adoption agreement, and the timing in which they will be used.
By establishing this policy, sponsors can provide a clear framework for the management of forfeitures, helping all parties involved to understand how these funds will be allocated.
Importance of Familiarity with Plan Provisions
It’s vital for plan sponsors and fiduciaries to familiarize themselves—or refamiliarize themselves—with the provisions in their plan documents regarding forfeitures. Understanding the specific language and guidelines will help in compliance with IRS regulations and in defending against potential legal challenges.
By being proactive and informed, plan sponsors can better navigate the complexities of forfeitures in employee benefit plans.
We’re Here to Help
For more information about managing forfeitures in employee benefit plans, contact your Moss Adams professional.