In February 2023, the IRS released proposed regulations that address how plan administrators should treat and report contributions that have been forfeited back to their retirement plans. In response to this new guidance, you may need to tweak how and when you use forfeitures — and update your plan document accordingly. Fortunately, many of these changes will be quick and simple to implement.
What are retirement plan forfeitures and why are they important?
If one of your employees fails to meet the minimum years of service required for vesting, all or a portion of employer contributions made to their retirement account will be forfeited and then reabsorbed into the plan trust when they terminate.
Your plan can use these forfeitures, but when and how your plan uses them matters.
For your retirement plan to be considered “qualified” in the eyes of the IRS (and therefore deductible), it must operate following a certain set of guidelines outlined in the Employee Retirement Income Security Act (ERISA). The regulations released last year proposed new guidelines for when and how you should use forfeitures.
How are forfeitures currently treated under US tax law?
Under current law, the forfeiture rules differ for defined benefit and defined contribution plans.
Defined Benefit Plans
Treasury Regulation 1.401-7, which was first promulgated in 1963, states that — barring a plan termination or complete discontinuance of plan contributions — forfeitures cannot be used to increase the benefits of other participants that they wouldn’t have otherwise received. It also states that forfeitures must be used “as soon as possible” to reduce employer contributions made to other participants in the plan. And lastly, it permits plan sponsors to estimate future forfeitures and apply those funds prospectively to reduce employer contributions as long as discrepancies between anticipated and actual forfeitures are reflected in future contributions.
Defined Contribution Plans
The Treasury Department has not released official regulations surrounding forfeitures in defined contribution plans. Instead, revenue rulings, non-binding IRS releases, and court cases have set industry standards. The rule of thumb is that plan sponsors should not place forfeitures in a suspense account to accumulate earnings indefinitely. The expectation is that funds be used within the same year they were forfeited to either (1) pay for plan expenses, or (2) offset employer contributions for other participants.
What’s in the proposed regulations?
The proposed regulations (REG-122286-18) would amend Treasury Regulation 1.401-7 to not only amend forfeitures guidance made for defined benefit plans, but also formalize expectations for forfeitures under defined contribution plans.
Defined Benefit Plans
The regulations prescribe how plan sponsors should estimate future forfeitures. They should use “reasonable actuarial assumptions” to estimate future forfeitures so that minimum funding requirements are met. Differences between estimates and actual should increase the plan’s minimum funding requirements in future years.
Defined Contribution Plans
The regulations outline the three instances where forfeitures may be used:
- To pay plan administrative expenses,
- To reduce employer contribution under the plan, or
- To increase benefits to other participants’ accounts in accordance with terms outlined in the plan document.
The regulations also give administrators additional time to use forfeitures. Instead of using them by the end of the plan year in which the forfeiture occurred, the regulations say that they can be used by the end of the following plan year.
Why are forfeitures such a hot topic right now?
In the last year, we’ve seen numerous court cases that contest plan sponsors’ use of forfeitures. In Perez-Cruet v. Qualcomm Inc., for example, the plaintiff — who was a former participant in the company’s 401(k) plan — argues that Qualcomm used retirement plan forfeitures in a way that benefitted the plan at the expense of its participants. Qualcomm had used forfeited employer contributions to defray future matching contributions rather than to offset the plan’s administrative expenses, which are charged to participants. The court, which has yet to hear the case, will determine if Qualcomm violated the ERISA and if plan administrators breached fiduciary duties.
In light of recent court cases, what are your fiduciary responsibilities?
The Qualcomm case is just one of many. Similar cases have been brought against Intuit, Clorox, Thermo Fischer, and HP. The American Bar Association discusses a few reasons why these lawsuits may not be successful, but the fact that they are not being dismissed should encourage you to update your plans and operations to comply with existing guidance from the IRS and the ERISA.
Proposed regulations like the newest guidance on forfeitures are not legally binding, but they are often treated as authority in court cases to bring context to the Internal Revenue Code or the ERISA. If written into law, REG 122286-18 would apply to plan years beginning on or after January 1, 2024. In light of the proposed guidance and the uptick in court cases surrounding forfeitures, there are a few things you and your tax advisor should consider:
- Figure out how you and your service providers have been applying forfeitures within your plan and ask yourself whether your plan document allows this.
- Review your plan document to see if its language allows for flexibility in how you use forfeitures.
- Determine if you want to implement a specific rule of order for how you use forfeitures.
- Decide whether you want to adopt REG 122286-18 now, even before it is finalized.
- See if your calculation and use of forfeitures has been properly recorded.
If you have any questions about current or proposed forfeiture regulations, please contact a member of LaPorte’s Employee Benefit Plan Services Group.