Lawsuits alleging misuse of forfeitures in retirement plans continue in the news with mixed results. But there is no need to wait for a final outcome wondering if it will be favorable to you and your clients. There are strategies you can use now to avoid these lawsuits altogether.

Speaking of waiting, time is running out to take advantage of IRS relief for using built-up forfeitures not timely used in prior years. You have until the end of 2025 to utilize forfeitures accumulated over time – whether accumulated over the last few years or decades ago.

This blog shows you how to take advantage of the IRS forfeiture relief and prevent any potential forfeiture lawsuits. Helping clients comply with the law and avoid lawsuits demonstrates how you can be a valued resource.

Forfeiture Use in Retirement Plans

In early 2023, the IRS released proposed regulations on general forfeiture rules. Most of the guidance provided has been industry standard for decades. For example, the proposed regs advised that a defined contribution (DC) (i.e., 401(k) profit sharing plan or ESOP) plan document should have provisions detailing how and when forfeitures will be used or allocated.

The IRS also clarified that forfeitures in a DC plan may be used for any of the following:

1. paying plan administrative expenses,
2. reducing employer contributions, or
3. increasing benefits in other participants’ accounts.

Many plans and their documents already comply with these guidelines.

However, there is one forfeiture aspect that tends to be missed – timely use of forfeitures. The IRS wants forfeitures to be used no later than 12 months after the close of the plan year in which the forfeitures are incurred. Unfortunately, some plans have built up forfeiture balances that have not been properly used for a long time.

Transition Rule Ends In 2025

The IRS considers it to be an operational failure if forfeitures remain unused beyond the 12-month deadline. Thankfully, the proposed regs provide transitional relief for old forfeiture balances. For any forfeitures incurred during any plan year that begins before January 1, 2024, the IRS will treat those forfeitures as having been incurred in the first plan year that begins on or after January 1, 2024.

For example, suppose you take over a plan in 2024 with a calendar year end from another TPA. You notice there is a balance in the system that transfers over and is simply labeled “forfeitures”. It is a large sum and the plan sponsor was unaware of this “forfeiture” account. Under the proposed reg’s transition rule, you can consider the full amount in the “forfeiture” account to be forfeitures incurring in the 2024 plan year. As such, the plan sponsor has until December 31, 2025, to fully use those forfeitures.

Now is the time to review forfeiture balances for all DC plans. Any forfeitures incurred prior to 2025 should be fully utilized through one or more of the three options listed above or in the plan document. Doing so satisfies the conditions for the transitional relief provided by the IRS and keeps your DC plans compliant.

Defined Benefit Plan Forfeitures

We mainly focus on forfeitures in DC plans, but they also can occur in defined benefit (DB) (i.e., pension) plans. For DB plans, the proposed regulations state that reasonable actuarial assumptions should be used to determine the effect of expected forfeitures on the present value of plan liabilities under the plan’s funding method.

Differences between actual forfeitures and expected forfeitures will increase or decrease the plan’s minimum funding requirement for future years, pursuant to the plan’s funding method. Therefore, DB plans do not have to worry about whether forfeitures are timely used to pay expenses or increase the benefit accrual.

The Rise of Forfeiture Lawsuits

Lawsuits filed in the past few years allege that plan fiduciaries improperly use forfeitures. Both sides claim victories based on the early results. Consequently, there is no clear direction yet on how these lawsuits will affect plan administration. However, you can assist clients now by discussing the following strategies for preventing a forfeiture lawsuit altogether.

Paying Plan Expenses With Forfeitures

These lawsuits generally make the same claim. Participants believe fiduciaries – if given the discretion – have an obligation to pay plan expenses with forfeitures before they can be used to reduce an employer’s contribution obligation (e.g., matching or profit sharing contribution). Participants argue that forfeitures are plan assets and must comply with the exclusive benefit rule.

The first step in preventing these types of lawsuits is determining who is paying plan expenses. If the employer or plan sponsor is paying plan expenses, then there is minimal risk of a forfeiture lawsuit. On the other hand, if plan expenses are deducted from participants’ accounts, then further analysis is needed with step two.

The second step is determining whether forfeitures are used to reduce a contribution obligation before offsetting plan expenses which would have been deducted from participants’ accounts. If so, then a plan sponsor should move to the third step of considering one of the following strategies to prevent a future lawsuit:

1. Remove any discretion in the plan document for the fiduciary to use forfeitures to pay plan expenses (see section below).
2. Switch operations to use forfeitures to pay plan expenses first, then any remaining amount can be used to reduce a contribution obligation.
3. Change policy to have the employers pay for plan expenses instead of those expenses being deducted from participants’ accounts.

Specifying the Use in the Plan Document

The foundation for forfeiture lawsuits relates to discretion provided to the fiduciary in the plan document. A few restatement cycles ago, most pre-approved plan documents changed their forfeiture section to allow full flexibility in how forfeitures were used. Specifically, the fiduciary had the discretion to use any of the three permissible methods – pay plan expenses, reduce employer contributions, or increase benefits – and could switch the method year to year if desired.

The document change was made to ease plan administration as the plan sponsor previously had to specify in the document which of the three methods to use and in what order. For example, the document would state “forfeitures would be used to offset employer contributions first. If any forfeitures remain, pay plan expenses, then increase participant benefits.” Consequently, the plan sponsor needed to timely amend the document in order to make any modification to that specific language.

If your clients are concerned about a forfeiture lawsuit, they should return to the old method. In other words, the plan sponsor should specify in the document that forfeitures will be first used to reduce the employer’s contribution obligations. In doing so, the plan sponsor takes any discretion away from the fiduciary and eliminates any alleged fiduciary breach.

Don’t Forfeit The Forfeiture Relief

Using forfeitures can be a forgotten piece of plan administration – especially if forfeitures don’t occur each plan year. Make sure to use the transitional relief provided by the IRS to clean up any old forfeiture balances before the end of 2025. Although the regulations providing the relief are not finalized, the IRS allows plan sponsors to rely on them for periods preceding the applicability date.

In addition, if your clients are looking to avoid forfeiture lawsuits, they should consider how they are currently using forfeitures in their plans. Why wait for future legal decisions when they can consider an operational or document change now to prevent any potential lawsuit. Helping clients avoid problems with this oft-forgotten administrative task demonstrates your value in being their service provider.

---

About the Author

Brian Furgala, Esq., CPC, QPA is Senior Director, Retirement Services Strategy for PenChecks, a leader in outsourced retirement plan distribution processing and Automatic Rollover/Missing Participant IRAs and related services. His broad experience as an ERISA attorney and senior executive for several leading retirement plan service providers gives him a unique perspective on the industry.

The views expressed in this article are those of the author and do not necessarily represent the views of PenChecks Trust®, its subsidiaries or affiliates.

---

PTCA-2024121