What are Plan Forfeitures?
Forfeitures are generated when a terminated participant who is not fully vested receives a plan distribution of his or her account balance or accrues five consecutive one-year breaks in service. For example, a 40% vested participant with a profit sharing account balance of $1,000 would receive a distribution of $400, and $600 would be placed in the plan's forfeiture account. Funds may be moved to the forfeiture account upon direction of the trustee for a zero-percent vested terminated participant. Forfeitures are also generated upon ACP test failures where the match refunds required are not 100% vested.
How are Plan Forfeitures Used?
When a plan accrues a forfeiture account, the funds may not be distributed back to the employer. Instead, the forfeitures must be used as specified in the plan document. Here's how:
Participant Buy Back
Generally, forfeitures may first be used to restore the non-vested portion of the accounts of re-employed participants who take advantage of the plan's "buy back" provision. In order to have forfeitures restored to his or her account, a participant must return to work before accruing five consecutive one-year breaks in service. At that time, the participant has a period of time, not to exceed five years from his or her original distribution date, to re-deposit his or her employer contributions to the plan. Normally, the participant must re-deposit the original distribution amount. For defined benefit plans, investment earnings on the distribution are also required in the "buy back."
Although it is extremely rare, this "buy back" might occur. If it does, the employer may use funds from the forfeiture account to restore the previously forfeited portion of the participant's account. If there are not enough funds in the forfeiture account to cover the amount required, the employer might be required to make an additional contribution to complete the restoration.
It is conceivable the participant could terminate and take a distribution again before becoming 100% vested. At that time, his or her non-vested balance would once again go to the forfeiture account.
Pay Plan Expenses
A more common use of the forfeiture account is to pay the administrative expenses of the plan. This would include payment to auditors, CPAs, or third-party administrators that provide services to the plan. All or a portion of the forfeiture account may be distributed to pay these invoices, provided the plan document allows for it. If there are forfeitures remaining after payment of expenses, the document will dictate how these should be used. Generally, forfeitures will either reduce the employer contribution or be allocated in addition to it.
Offset an Employer Contribution
Forfeitures that reduce a contribution are used to offset it. For example, an employer may allocate a $20,000 profit sharing contribution. If there were $5,000 in the forfeiture account, the employer would deposit $15,000 and use the $5,000 in forfeitures to complete the allocation. Alternatively, the employer may allocate a matching contribution each pay period but use the forfeiture account to fund it rather than depositing the match amount. Employers using forfeitures to reduce a contribution should keep in mind only the amount actually deposited (not offset by forfeitures) is deductible. Forfeitures cannot be used to offset employee deferral contributions or loan repayments.
Reallocate Alone or in Addition to
If forfeitures are added to the contribution, they are generally allocated in the same manner. Assume the employer in the example above wishes to make a $20,000 profit sharing contribution. The employer would deposit $20,000 but allocate $25,000. The $5,000 from the forfeiture account would be allocated in the same method as the $20,000 profit sharing contribution. If the plan's allocation method were age-weighted, for example, the $5,000 would be allocated using that method rather than pro-rata based on compensation or account balance.
Use All Plan Forfeitures Every Year
Except under limited circumstances, forfeitures should not be held unallocated in a suspense account. In Revenue Ruling 80-155, the IRS states that a defined contribution plan will not be qualified unless all funds are allocated to participants' accounts in accordance with a definite formula defined in the plan. Additionally, the language in Revenue Ruling 84-156 suggests that any forfeitures remaining after expenses are paid must be applied to provide benefits to the participants, either in payment of a portion of the employer's contribution (the "offset" described above) or as an additional employer contribution. This is consistent with the general principle that all amounts must be allocated under a defined contribution plan.
The plan document will dictate the method by which forfeitures must be used or allocated. Although the method may be modified via amendment, the amendment must not violate the anti-cutback rule or otherwise conflict with any of the rules or regulations pertaining to qualified plans. This article is merely a synopsis of the ways a forfeiture account may be generated or used, and the examples given may not apply to all plans. If you have questions or concerns regarding the use of forfeitures specific to your plan, please contact your consultant at MBC.
The general information provided in this guide is based upon complex requirements of the Internal Revenue Code and Treasury Regulations. It is provided with the understanding that, for the purposes of this publication, MBC Retirement Services, Inc. is not engaged in rendering legal, accounting, or other professional services. Although care has been taken to present the material accurately, MBC Retirement Services, Inc. disclaims any implied or actual warranties as to the accuracy of any material herein and any liability with respect thereto.