Proper utilization of plan forfeitures in a 401(k) profit sharing plan requires utilization both in form and timing, as prescribed by the governing plan document.
Most plan forfeitures are derived from non-vested accounts of plan participants. Generally a participant forfeits their non-vested account balance upon the earlier of 1) total payout of the participant’s account, or 2) 5 1-year breaks-in-service.
Once generated, the plan document indicates how and when the forfeitures are to be utilized. As a best practice, we recommend the document provide they be used for payment of plan expenses (after first being utilized to reinstate forfeitures applicable to rehired employees). Where forfeitures are not utilized for payment of plan expenses, or where the forfeitures exceed expenses incurred, we recommend the document provide they then be used to reduce employer contributions.
Regardless of how they are used, the important point is that they must be utilized, and cannot be “held in suspense”. The plan document also dictates the timing of the utilization of the plan forfeitures, generally for the current or succeeding plan year.
Additionally, it’s important to anticipate participant forfeitures and their utilization, as some plan designs may be a “ticking time bomb” for creating a mandatory employer contribution requirement. How’s that? Let’s say at some point in the past, there were employer contributions made to the plan, like profit sharing or matching contributions. Depending on the length of service of the plan participants who shared in those contributions, some of the dollars may be partially vested, and subject to forfeiture. Now, let’s say that the plan has been amended to include a safe harbor matching contribution. Further, let’s say the plan is currently only receiving 401(k) elective deferral and safe harbor matching contributions, such that the plan is “deemed not top heavy”, though the top heavy ratio exceeds 60%. Any current year forfeitures not utilized to pay plan expenses must be used to reduce the employer contribution.
(Note, the IRS has taken the position that safe harbor matching contributions are not unlike QNEC contributions, and QNEC’s cannot be funded through the use of forfeitures. However, some plan EGTRRA documents contain language permitting the use of forfeitures for funding safe harbor contributions, and those EGTRRA documents were approved by the IRS. It is anticipated that the IRS will not approve PPA documents containing such language.)
So, in our example, let’s say the forfeitures exceed plan expenses, and will not be used to reduce the safe harbor matching contribution. Under such a scenario, the plan forfeitures would need to be reallocated. As such, the plan will no longer consists solely of 401(k) elective deferrals and safe harbor matching contributions for the applicable plan year. Therefore, the plan would lose its “deemed not top heavy” exception, and would be subject to providing top heavy minimum contributions, assuming at least one key employee received an allocation (including any 401(k) elective deferrals, or company contribution or forfeiture reallocation). Where the top heavy minimum was not provided via the safe harbor matching contribution or forfeiture reallocation, an additional employer contribution would be required, and may not have been anticipated.
Therefore, as a best practice, the plan design should include a discretionary matching contribution provision that meets the requirements for automatic passage of the ACP testing. Because the discretionary matching contribution meets the ACP safe harbor, the plan will retain its’
“deemed not top heavy” status, and will not be subject to top heavy minimum requirements. This allocation mechanism alleviates any top heavy minimum issues that may have been unforeseen or otherwise unavoidable.
Understanding the many rules applicable to retirement plans is not only essential to maintaining the qualified status of your 401(k) plan, but also essential in providing the greatest opportunities with the least obligations for the employer sponsoring the plan. This is just one among many considerations we make in designing 401(k) and profit sharing plans.