Forfeiture Accounts: Don’t Let Good Money Go Bad – Part 1
Forfeitures certainly look like good money – a versatile stockpile of assets that can only be put to positive uses with a positive outcome. When they are used right, this is absolutely true. Participants are happy because they may pay less from their personal accounts for plan expenses and receive extra allocations of cash, and employers may have access to cash that can be used to reduce employer contribution costs or administrative expenses that the employer would normally pay out of pocket. However, looks may be deceiving, as forfeitures are easy to accumulate, just as easy to overlook, and failing to use them correctly can result in time-consuming, and potentially costly, consequences.
Generally, a defined contribution plan generates forfeitures when participants receive a full distribution or experience a significant break in service before they are fully vested in their plan account, and must be used in the manner specifically chosen in the plan document. If knowledge is power, then step one on the path to forfeiture empowerment is to make sure you are receiving regular updates, at least quarterly, regarding your plan’s forfeiture account balance from your asset custodian. Once you know the amount of assets you are working with, then step two is to make sure you are familiar with the terms of your plan document so you know how to manage your plan’s forfeiture account. Before we can understand how forfeiture account management can go wrong and the problems it can cause, we must understand how and when forfeitures can be used. In this Part 1, we’ll discuss how they should be used, and stay tuned for Part 2 for a discussion about when forfeitures should be used, and why it should matter to you.
HOW TO USE FORFEITURES:
The most important thing to know about how you may use forfeitures is that you have limited discretion. By the time your plan is generating forfeitures, you have already restricted yourself to a specific use (or uses) in your plan document. Most plan documents provide that forfeitures should be used to offset plan administrative expenses or offset employer contributions. Some documents will also allow a plan administrator to allocate forfeitures to the plan participants, usually in proportion to each participant’s eligible compensation. Sounds simple, just check your plan document to be sure you know what is allowed within your own plan, and do not deviate from the plan provisions.
However, if you read it very carefully, you may find provisions buried in the forfeiture section of your plan document that may restrict your discretion to use them even further. The most common examples are provisions requiring forfeitures be used in a particular order, and those that provide for a default use for leftover amounts. Some plan documents require that forfeitures first be used to offset administrative expenses before they can be used to offset employer contributions, while others require that all forfeitures that are not used to offset administrative expenses and employer contributions within a certain timeframe be allocated to plan participants. You may not recognize these provisions if you only take a cursory look at your plan document or adoption agreement. However, if overlooked, these restrictions may cause serious problems down the road.
Also, with regards to employer contributions, keep in mind that the IRS has taken the position that forfeitures should not be used to offset safe harbor contributions, Qualified Non-Elective Contributions, and Qualified Matching Contributions because they were not 100% vested at the time the employer made the contribution to the participant. So, if your plan document specifically allows you to use forfeitures to offset these employer contribution types, then you should be able to rely on your tax-qualified plan document (the IRS is not expected to approve this feature in the future, so enjoy it while you have it). Alternatively, if your plan document does not specifically allow you to offset these contribution types, then only use forfeitures to offset employer contributions that are not required to be immediately, 100% vested.
So, take a few moments to request your account statements and get a grip on how your plan allows you to use your forfeitures. Then, check back in for Part 2, where we will discuss the timeframe in which forfeitures should be used, and take a glimpse at the trouble you can encounter if you are not familiar with your forfeiture account and plan document.