Recent Challenges to Plan Forfeitures

Recent lawsuits are challenging 401(k) plan sponsors’ use of forfeitures to reduce employer contributions.  Such practice is a long-standing precedent permitted by the Internal Revenue Service “IRS.” Plaintiffs in these suits claim that the decision on how to apply forfeitures is a fiduciary determination.  The plaintiffs further allege it is a prohibited transaction to not apply forfeitures for the benefit of participants.  

History of Retirement Plan Forfeitures. 

When a participant terminates employment before becoming fully vested in their qualified retirement plan account, the non-vested portion may become a “forfeiture.”  

A 401(k) plan may provide for the use of plan forfeitures to pay reasonable administrative expenses.  The IRS approved this use of forfeitures in Rev. Rul. 54-156.  To the extent forfeitures exceed the amount required to pay expenses, the excess would be applied to reduce employer contributions or as additional allocations.  When a plan takes this approach, the forfeitures are in effect “allocated” for the benefit of the participants in proportion to how the expenses are paid (e.g., pro rata based on account balances) rather than how an employer contribution would be allocated (e.g., pro rata based on compensation). 

Accordingly, forfeitures are often used to reduce employer contributions, a practice that has been permitted by the Internal Revenue Service (“IRS”) since before the Employment Retirement Income Security Act of 1974 (“ERISA”) was enacted.  

Some Reasons Why Using Forfeitures to Reduce Employer Contributions Should NOT Be Restricted.  

1. IRS Reaffirmed Its Position in 2023:

The IRS permits 401(k) plan forfeitures to be used for any of three permitted purposes:  
  • Paying plan expenses. 
  • Reducing employer contributions. 
  • Making an additional allocation to participants.  

The IRS requires forfeitures to be applied for these purposes and removed from the initial, separately kept forfeiture account within 12 months of the end of the year in which the forfeiture occurred. In its most recent guidance, the IRS reminded plan sponsors that plan language must first grant the use of forfeitures for these three purposes.  

2. DOL Lawsuit Decision Consistent with IRS:

The Department of Labor (“DOL”) has only expressed concern about applying forfeitures to reduce employer contributions when it resulted in a violation of a plan provision requiring that the forfeiture must first be applied toward plan expenses. This decision is consistent with the IRS because, under Title 1 of ERISA, fiduciaries must administer plans in accordance with their terms. 

Is This Application an ERISA Violation?  

There are many reasons to consider why applying forfeitures to reduce employer contributions is not a fiduciary activity and thus not an ERISA violation, including:  

  • The DOL has not objected to the IRS: Although it is the DOL’s responsibility to determine whether a prohibited transaction occurs, the DOL has indicated that it will not take positions contrary to the IRS on plan qualifications issues, and it has never done so in the past.  
  • It is likely not a fiduciary decision: Long-standing ERISA authority says that decisions such as plan design, how to fund a plan, and the level of contributions are rather settlor decisions. The law does not require plan sponsors to maximize their contributions, nor does it require that if a plan sponsor does decide to make a discretionary contribution to always contribute the maximum amount permitted by law or the plan. Applying forfeitures to reduce contributions is merely an indirect way of setting the level of employer contributions, a settlor function. Moreover, the IRS permits forfeitures to offset both contributions required by the plan and discretionary contributions in Rev. Rule 71-313. 
  • Forfeitures are derived from excess employer contributions: Forfeitures occur because employer turnover cannot be factored into the determination of contributions to defined contribution plans. When a participant terminates employment, they forfeit unvested employer contributions. It is important to keep in mind, however, that if the participant is rehired within the window period, the forfeiture may be required to be restored at the employer’s expense if the forfeiture account is not sufficient.  
  • Plans where the employer pays all fees directly: Although this practice is uncommon, it exists. It is a disincentive for employers to pay plan fees directly.  
  • Terminating plans: There is also a requirement that a terminating plan must allocate all assets, including forfeitures, at the time of termination. However, if plan expenses do not use up the forfeitures, under the plaintiff’s untested theory, applying the balance to reduce final employer contributions would be an ERISA violation. Participants would then receive additional contributions in excess of those required by the plan document.  
  • Sponsors can reduce their employer contributions as a response: The law is clear that plan design, including setting the level of employer contributions, is not fiduciary in nature. It would not benefit participants and would make the exercise counterproductive if plan sponsors could not apply forfeitures toward employer contributions.  

How Plan Sponsors Can Protect Themselves.  

The recent challenges may end up changing whether certain plan language permits the use of forfeitures to reduce employer contributions.  All plan sponsors should review their plan language to ensure that their use of forfeitures is permitted by the plan document. Listing all three permissible uses is preferable. Ongoing plan sponsor discretion regarding the use of forfeitures may also want to be eliminated by establishing a written order in which forfeitures must be used in the plan document. However, this removal of discretion impedes employer flexibility and may be premature.  

How Can BrownWinick Assist You?  

If requested, BrownWinick can assist you in understanding plan forfeitures, whether your plan’s language permits the use of forfeitures to reduce employer contributions, and the potential impact these recent lawsuits may have on your plan. Contact Caleb Brus at 515-558-8867. 

Special thanks to summer associate Grace Kruse for her assistance with this blog.