Plan forfeitures must match plan document
It’s a routine matter for employees to forfeit retirement plan benefits. Even so, plan sponsors can’t afford to become blasé about it; ERISA demands more than an “easy come, easy go” attitude about the matter.
Generally, defined contribution plan participants can forfeit benefits when they leave their companies with unvested dollars still sitting in their accounts (except under circumstances described below). Those forfeited dollars can come from two sources: matching contributions you’ve made to their deferrals, and/or nonelective contributions you’ve made on their behalf.
The amount of the unvested dollars typically classified as forfeited depends on the vesting schedule you’ve adopted in your plan document, and the timing of an employee’s departure. For example, if you use a three-year cliff vesting schedule, all employer funds set aside for participants who leave before three years are (normally) forfeited, and after three years, participants are 100% vested.
With a graded vesting schedule, if your plan requires the maximum six years of service before full vesting, participants would only be entitled to keep 20% of matching or other employer contributions after two years of service, 40% after three, and so on until reaching 100% after six years of service. (You can opt instead for faster graded vesting schedules if you want to be more generous; ERISA only sets outer limits.) Of course, participants’ own contributions to the plan are immediately vested, as are qualified nonelective contributions and employer safe harbor contributions.
All of this assumes, however, that your plan document defines forfeiture and what happens to nonvested benefits when an employee leaves. For example, the document may state that, if the participant is 0% vested, he or she forfeits the account immediately on termination of employment. In addition, the document may provide that the unvested portion of a terminated participant’s account will be forfeited in the year of termination or after a five-year break in service. Forfeitures are generally held in a “forfeiture account” to be used when the plan document specifies. Generally, plan sponsors use forfeitures to pay plan expenses, reduce employer contributions and/or use in addition to any employer contributions being made.
Why might you hold forfeitures for a period of five years? Under ERISA, a former plan participant who returns to the company and rejoins the plan within five years has another crack at claiming those unvested assets. If the company had used these funds prior to the participant’s return, it will need to make contributions to the plan to restore the account.
In either case, however, ERISA sets a high bar for returning employees to regain title to those assets. Specifically, if the former employee had received a distribution of any vested funds when leaving the company, that employee would have to return all of those dollars to the plan before having the opportunity to get those unvested dollars back. And if the returning employee cleared that first hurdle, the unvested funds to be restored would still be unvested.
Plan recordkeepers must keep scrupulous records of every penny in your plan and which of the many buckets they belong in. Review how your recordkeeper is tracking forfeitures. Finally, be sure that the way you’re handling forfeitures is consistent with the fine print in your plan document that prescribes these procedures.
How to handle forfeited funds
However you define forfeiture, you have to do something with the unvested dollars left in the plan when a participant leaves the company. So, what are your options? Let’s summarize:
You can redeploy those dollars toward your commitments to matching or nonelective contributions to plan participants. Or if you’re feeling generous, allocate them to participant accounts. To do so, however, you’ll need to have language in your plan document that describes how those funds would be allocated among participants and eligibility requirements. Also, these allocations would count toward the participant’s limit on total annual additions, so you might not be able to allocate all forfeitures that way.
You can also use forfeited dollars to pay reasonable plan expenses. Finally, you can use them to restore previously forfeited amounts to participant accounts. That is, if a former employee returns within the five-year window and returns previously distributed funds, as required, the dollars forfeited by other employees get recycled into the nonvested accounts of those returning employees.
Chances are, you won’t need to exercise this last option because it’s not a common occurrence for former participants to return within five years and restore distributions they took when they left. Still, it’s a good tactic to be aware of should the need arise.
Whichever path you choose, you have a deadline to get it done: the end of the plan year following the plan year in which the forfeiture occurred.