April 18, 2023
By: Melanie N. Aska
The IRS recently issued Proposed Regulations that clarify and update existing rules governing how and when forfeitures must be used in qualified defined contribution (e.g., 401(k)) and defined benefit retirement plans.
Forfeitures arise under a plan when a participant terminates employment for any reason before becoming 100% vested in his or her plan account (in the case of a defined contribution plan) or accrued benefit (in the case of a defined benefit plan), and thereby forfeits the non-vested portion of the account or accrued benefit.
Forfeitures in Defined Contribution Plans
Permitted Uses of Forfeitures. Consistent with changes made by the Tax Reform Act of 1986 providing uniform rules for the use of forfeitures in defined contribution plans, the Proposed Regulations would clarify that forfeitures arising in any defined contribution plan (including in a money purchase pension plan) may be used for one or more of the following purposes, as specified in the plan document:
- To pay plan administrative expenses;
- To reduce employer contributions under the plan; or
- To increase benefits in other participants’ accounts in accordance with plan terms.
The use of forfeitures to reduce employer contributions would include the restoration of inadvertent benefit overpayments and the restoration of conditionally forfeited participant accounts that might otherwise require additional employer contributions.
Deadline for Using Forfeitures. The Proposed Regulations would also provide a clear rule requiring when forfeitures must be used in defined contribution plans. The Proposed Regulations would generally require that plan administrators use forfeitures no later than 12 months after the close of the plan year in which the forfeitures are incurred. This deadline is intended to simplify plan administration by providing a single deadline for the use of forfeitures that applies for all types of defined contribution plans (e.g., 401(k), profit sharing and money purchase pension plans) and to alleviate administrative burdens that may arise in using or allocating forfeitures that are incurred late in a plan year.
The Proposed Regulations would provide a transition rule related to the 12-month deadline for using forfeitures in defined contribution plans. Under the transition rule, forfeitures incurred during any plan year that begins before January 1, 2024, would be treated as having been incurred in the first plan year that begins on or after January 1, 2024. Accordingly, those forfeitures must be used no later than 12 months after the end of that first plan year.
Although nothing in the Proposed Regulations would preclude a defined contribution plan document from specifying only one use for forfeitures, the plan may fail operationally if forfeitures in a given plan year exceed the amount that may be used for that one purpose.
For example, if (1) a plan document provides that forfeitures may be used solely to offset plan administrative expenses, (2) plan participants incur $25,000 of forfeitures in a plan year, and (3) the plan incurs only $10,000 in plan administrative expenses before the end of the 12-month period following the end of that plan year, there would be $15,000 of forfeitures that remain unused after the deadline established in the Proposed Regulations. Thus, the plan would incur an operational qualification failure because forfeitures would remain unused at the end of the 12-month period following the end of that plan year. The plan could avoid this failure if it were amended to permit forfeitures to be used for more than one purpose.
Forfeitures in Defined Benefit Plans
Internal Revenue Code Section 401(a)(8) provides that forfeitures arising in a defined benefit plan must not be applied to increase the benefits any participant would otherwise receive under the plan. (This rule ensures that the plan will satisfy the basic rule requiring a defined benefit plan to provide systematically for the payment of “definitely determinable benefits” to employees over a period of years, usually for life, after retirement. Benefits under a defined benefit plan are not “definitely determinable” if funds arising from forfeitures on termination of employment may be used to increase benefits for the remaining participants).
Existing IRS Regulations Section 1.401-7(a), promulgated in 1963, requires that defined benefit plans use forfeitures “as soon as possible to reduce the employer’s contributions under the plan”. However, none of the provisions of the Code that set forth minimum funding requirements for defined benefit plans (i.e., Code Sections 430, 431 and 433) – all enacted years after 1963 − allow an employer’s required contributions for minimum funding purposes to be offset by forfeitures of accrued benefits.
Instead, all of these minimum funding provisions of the Code require the use of reasonable actuarial assumptions to determine the effect of expected forfeitures on plan liabilities. Any difference between actual forfeitures and expected forfeitures is reflected in future employer contributions to the plan required under Code Section 412 pursuant to the funding method used for the plan under Code Section 430, 431 or 433.
The Proposed Regulations would eliminate the requirement in existing IRS Regulations Section 1.401-7(a) that forfeitures be used as soon as possible to reduce employer contributions because that requirement is inconsistent with the Code’s current minimum funding requirements. The Proposed Regulations would require a defined benefit plan to expressly provide that forfeitures may not be applied to increase participants’ benefits, and consistent with the Code’s existing minimum funding provisions, would permit the plan’s reasonable actuarial assumptions to anticipate the effect of forfeitures on the present value of plan liabilities under the plan’s funding method.
Proposed Effective Date
The Proposed Regulations would apply for plan years beginning on or after January 1, 2024. Thus, for example, the deadline for the use of forfeitures incurred in a plan year beginning during 2024 would be 12 months after the end of that plan year. Taxpayers, however, may rely upon the Proposed Regulations for periods preceding their applicability date. The public comment period for the Proposed Regulations is scheduled to close on May 30, 2023.
If you have any questions about the provisions discussed in this news alert, please contact Melanie N. Aska at maska@murthalaw.com or 617.457-4131.
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