On February 27, 2023, the Internal Revenue Service (IRS) issued a proposed rule to clarify the use of forfeitures in qualified defined contribution (DC) and defined benefit (DB) retirement plans. The rule would take effect for plan years beginning on or after January 1, 2024, but plan sponsors and administrators may rely on it immediately. Comments on the proposal are due May 30, 2023.

Background

A forfeiture is typically the money a retirement plan participant loses if they terminate employment before being fully vested. Forfeitures can also arise when there are average contribution percentage (ACP) test failures where the corrective matching contribution refunds are nonvested. Participants are always fully vested in their salary deferral contributions. Vesting is the process by which a participant obtains nonforfeitable rights to 100% of their accrued benefits, meaning employer matching and nonelective contributions. The amount that an unvested participant forfeits, or leaves behind in the plan, becomes an administrative issue for the plan.

DC Plans

The biggest changes in the proposed rule apply to DC plans and provide clarity on the use of forfeited funds, the dates by which they must be used and a transition period.

Uses for forfeitures. Under the proposed rule, DC plan documents must specify that forfeitures will be used for one or more of the following purposes:

• Paying plan administrative expenses
• Reducing employer contributions under the plan
• Increasing benefits in other participants’ accounts in accordance with the terms of the plan.

In the proposed rule, IRS warns employers that specifying only one use for forfeitures in the plan document could result in an operational failure if forfeitures in a certain year exceed the amount that may be used for that one purpose. To avoid this failure, the plan could be amended to permit forfeitures to be used for more than one purpose.

Deadline for using forfeitures. Under current rules, DC plans generally must use forfeitures by the end of the plan year in which they arise. The proposed rule revises the deadline to within 12 months following the close of the plan year in which forfeitures are incurred. For example, DC plan forfeitures incurred during the 2024 plan year must be used within 12 months after the end of that plan year. The deadline seeks to simplify plan administration and ease administrative burdens that arise when forfeitures occur late in a plan year. Plan sponsors must state this deadline in their plan documents.

Transition period. The proposed rule would apply for plan years starting in 2024, but a transition rule would permit accumulated forfeitures generated in any year before 2024 to be allocated as if the forfeitures originated during the 2024 plan year. This transition relief would apply regardless of the circumstances that caused forfeitures to accumulate over previous plan years. According to Kenneth Ginder of Verrill Law, it is presumed that “IRS included this generous transition period because it is aware that there are many plans with large forfeiture accounts, built up over numerous years, and it wants to provide plan sponsors with time to address this forfeitures issue.”

Next Steps

DC plan sponsors should:

• Review the terms of plan documents related to the use of forfeitures
• Determine whether the plan has forfeitures and, if so, the plan year when the forfeitures were incurred
• Review whether the forfeitures are being used timely and for proper purposes under the terms of the plan and current laws
• If plan documents are silent on forfeitures or are inconsistent with the proposed rules, amend the documents to comply with IRS guidance
• Decide whether an interim document amendment is necessary (for employers who will use the transitional rule to allocate accumulated forfeiture balances in 2024). An interim document amendment must be adopted by December 31, 2026 based on the proposed rule.
• Decide whether to amend plans to expand the permitted uses of forfeitures
• Work with recordkeepers to ensure compliance with updated rules
• Speak with counsel if the plan has sizeable forfeiture balances to ensure timely and proper allocation of these funds.

DB Plans

The proposal would align DB forfeiture rules with current IRS DB plan minimum funding requirements by eliminating the requirement that pension plan forfeitures be used as soon as possible to reduce employer contributions. Instead, reasonable actuarial assumptions are used to determine the effect of expected forfeitures on plan liabilities. Any difference between anticipated and actual forfeitures will be reflected in future contributions. This has no effect on plan funding or administration, as the update agrees with current practices regarding DB plan forfeitures.

Next Steps

According to WTW, “DB plan sponsors should ensure the language in their plans indicate[s] that forfeitures cannot be used to increase participant benefits before plan termination.”

Comments

Plan sponsors and administrators have until May 30, 2023 to comment on all aspects of the proposed rule. Additionally, IRS specifically requests comments on whether:

• The rules for the use of forfeitures in DB and DC plans could be further simplified to reduce administrative costs and burdens
• Any issues could arise concerning other unallocated amounts (in addition to forfeitures) with respect to qualified retirement plans and, if so, whether IRS should provide guidance on those issues. 

Stay tuned to the International Foundation for updates on the status of this proposed rule.

Developed by International Foundation Information Center staff. This does not constitute legal advice. Please consult your plan professionals for legal advice.