Forfeitures occur in an employee benefit plan when participants are terminated from employment, but are not fully vested in the employer’s contribution to their accounts.
This can be best illustrated through an example: An employer offers a profit sharing contribution for employees participating in its 401(k) plan. The plan document states that an employee must work for three years to be 100% vested in the employer’s contributions (0% vested until they reach three years). If an employee received $1,000 dollars in profit sharing contributions and was terminated two years after employment, the $1,000 would be forfeited from the employee’s account and allocated to a forfeiture account within the plan.
These forfeitures will build up throughout the plan year as employees are terminated. The balance of forfeited funds during a plan year can be used in a variety of ways. These include:
- Reduce future employer contributions, thus saving the plan sponsor money by reducing the amount they are contributing into the plan
- Allocate to current participants as an additional employer contribution
- Pay administrative expenses of the plan
- Restore employer contributions in participant accounts of employees that have been rehired within a specified amount of time
The plan sponsor is required to disclose how these forfeitures will be used in the plan document, and the sponsor will have to apply the forfeitures in that manner relatively quickly. The IRS has noted that forfeitures are to be exhausted during the plan year in which they are incurred, or no later than the following plan year in appropriate circumstances.
Overall, there are many factors that affect forfeitures such as a vesting schedule, how much to contribute to employee accounts and how forfeitures should be used. Employers and employees should be aware of how the forfeiture process works to prevent noncompliance and to prevent surprising amounts of forfeited retirement amounts.