In the last six months, several clients called me regarding substantial balances in a so-called “forfeiture account” in their 401(k) plans. A few of these clients have forfeiture accounts that violate the ERISA requirements. It is imperative that forfeitures be handled properly since both the IRS and the Department of Labor (DOL) on audit generally review how forfeitures have been handled by the plan.

The basic rule is that forfeitures must be allocated on an annual basis. Forfeitures should not be held over into later years. Failure to comply with this requirement can result in disqualification of the plan or potential penalties imposed by the DOL. Sometimes this failure is due to an accidental failure to timely deal with the forfeitures.

Proper disposition of forfeitures depends upon the terms of the 401(k) plan. For example, many plans first use forfeitures to pay proper plan expenses. However, the employer should make sure that the plan document specifically allows for payment of plan expenses. Otherwise, the payment of such expenses may result in plan disqualification or a prohibited transaction. We see many adoption agreements for prototype plans that do not provide for payment of plan expenses.

In addition, forfeitures can be used to reduce employer contributions including matching contributions and non-elective contributions. Finally, forfeitures can merely be reallocated to participants’ accounts as an additional amount for participants. Reallocation is somewhat typical for employers who have profit sharing plans that are not 401(k) plans.

Most notably, the IRS has recently taken the position that forfeitures cannot be used to offset safe harbor contributions under a regular or QACA safe harbor plan. Use for safe harbor contributions can also result in plan disqualification.

In addition, forfeitures cannot be used for certain corrections under the IRS Employee Plans Compliance Resolution System (EPCRS).

When a regulatory agency determines that forfeitures have been carried over, the agencies may require the plan sponsor to retroactively determine who should have received allocations each year. If your plan has a forfeiture account that includes amounts carried over from one year to another, you should review that account and take appropriate action so that the account does not include any carryovers. Of course, this creates a monetary burden and a significant administrative burden on employers.