What is the new transition rule for applying forfeitures in DC plans?
“What is the new transition rule for 2024 for applying accumulated forfeitures in defined contribution (DC) plans?”
ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.
A recent call with a financial advisor in Colorado is representative of a common inquiry related to plan forfeitures.
Highlights of the Discussion
The 2024 transition rule allows sponsors of DC plans to treat forfeitures accumulated from previous plan years as if they were 2024 plan year forfeitures and use them by the end of the 2025 plan year. Here’s some background information.
On February 27, 2023, the IRS issued proposed regulations for using forfeitures in tax-qualified retirement plans( (REG–122286–18). The proposed regulations extend the deadline by which plans must use forfeitures to the end of the plan year after the plan year in which the forfeitures occurred (e.g., end of the 2025 plan year to use 2024 forfeitures). Prior informal guidance from the IRS provided that forfeitures must be used or allocated in the plan year that they were incurred. Publication 4278 (Rev. 5-2010) (irs.gov). Importantly, the proposed regulations provide a transition rule that extends the deadline for using forfeitures accumulated in a plan year before 2024 in DC plans until the end of the 2025 plan year. The proposed regulations may be relied on until the final regulations are issued.
What Are Forfeitures in Defined Contribution Plans?
Employer contributions such as profit-sharing (nonelective) contributions and matching contributions to a defined contribution plan may be subject to a vesting schedule. The partially vested account balances of participants who terminate employment are often the source of forfeitures. That is because the nonvested portion of employer contributions are forfeited on the earlier of the date that an employee: (1) terminates employment and receives a distribution of their vested portion of employer contributions; or (2) works less than five consecutive plan years and incurs five consecutive breaks in service. In addition, excess matching contributions allocated to nonvested highly compensated employees in 401(k) plans that fail actual contribution percentage (ACP) testing may be forfeited in order to pass the ACP test.
Further, after searching for “lost” participants, if the plan disburses their vested account balances according to the plan document (e.g., IRA rollover, escheatment, etc.,), the nonvested portion would be forfeited. Before determining whether a participant is lost and forfeiting their nonvested account balance, a plan fiduciary should take all appropriate steps to locate missing participants. (See Missing Participants or Beneficiaries | Internal Revenue Service (irs.gov) and Missing Participants Guidance | U.S. Department of Labor (dol.gov)for further guidance on these steps).
Permitted Uses of Forfeitures In Defined Contribution Plans
Depending on plan document provisions, accumulated forfeitures can be used to
Pay certain plan expenses;
Reduce employer contributions; or
Be allocated as additional employer contributions.
2024 Transition Rule Relief
Fortunately, the proposed regulations recognize that forfeitures accumulated over the years may not have been used on a timely basis. Accordingly, the proposed regulations provide a special transition rule that gives plan sponsors additional time to use accumulated forfeitures. Specifically, forfeitures accumulated prior to January 1, 2024, will be treated as if they were first forfeited in the 2024 plan year. Since the deadline for using forfeitures is 12 months after the end of the first plan year in which the forfeiture occurred, this transition rule means that plan sponsors have until the end of the 2025 plan year to use all accumulated forfeitures in accordance with the terms of their plan documents.
Conclusion
The transition rule under the proposed regulations provides plan sponsors with an opportunity to use the 2024 plan year to “clean the slate” and treat forfeitures occurring before the 2024 plan year as first occurring in the 2024 plan year. Plan sponsors should ensure that these accumulated forfeitures are applied within the transition period that closes at the end of the 2025 plan year. The transition rule also presents an opportunity for plan sponsors to review their administrative procedures to help ensure plan operations comply with the requirement that forfeitures be used no later than the end of the plan year after the plan year in which the forfeitures occurred. Depending on how forfeitures may be used under the terms of the plan, using accumulated forfeitures could reduce the cost of future employer contributions, and/or defray reasonable plan expenses. This case is covered on our YouTube channel Understanding the 2024 Transition Rule for Forfeitures in DC Plans.