Earlier this year, the Department of the Treasury and the Internal Revenue Service (IRS) issued proposed regulations on the use of forfeitures by tax-qualified retirement plans. The changes, published in the Federal Register, provide clarity in a previously murky area for plan sponsors.
Forfeitures generally arise when a participant terminates employment before fully vesting in the retirement plan. A participant forfeits non-vested retirement benefits, usually following a plan distribution or a statutory period of consecutive one-year breaks in service.
What should a qualified retirement plan do with these accumulated forfeited benefits? Previous regulations for forfeitures under defined benefit plans did not reflect more recent minimum funding legislation and guidance. Adding to the confusion, recent forfeiture guidance for defined contribution plans was found only in an informal IRS newsletter. To address these issues and clarify permitted use of retirement plan forfeitures, the IRS issued proposed regulations that could apply to tax-qualified retirement plans beginning as early as January 1, 2024.
DEFINED BENEFIT PLANS
For defined benefit plans, the proposed regulations remove outdated guidance and eliminate the prior requirement that forfeitures be used as soon as possible to reduce employer contributions, which conflicted with more recent minimum funding rules. Instead, the proposed regulations require employers to use reasonable actuarial assumptions in determining the effect of plan forfeitures and the amount of plan contributions. The proposed regulations also continue to prevent forfeitures from increasing other participants’ pension plan benefits prior to terminating the plan or completely discontinuing employer contributions.
DEFINED CONTRIBUTION PLANS
The proposed regulations clarify that all defined contribution plans (including money purchase plans) may use forfeitures either to:
Pay plan expenses
Reduce employer contributions
Increase retirement benefits in participant accounts
The proposed regulations require that a defined contribution plan expressly state whether plan forfeitures can be used for one, two or all three of the above purposes.
In addition, the proposed regulations extend permitted forfeiture use by a defined contribution plan to 12 months after the plan year in which the forfeiture arose. Prior informal IRS guidance suggested that defined contribution forfeitures must be used no later than the year in which the forfeitures occurred, which proved challenging for plan administrators, particularly with respect to forfeitures that arose late in the year. This proposed change should give plan sponsors a bit more breathing room and certainty when dealing with plan forfeitures.
Under the proposed regulations, there is also a transition rule for forfeitures that occurred prior to January 1, 2024. Forfeited amounts in a defined contribution plan before January 1, 2024, are treated as occurring in the first plan year that begins after this date. Thus, for a calendar-year plan, forfeitures that arose prior to January 1, 2024, must be used for plan expenses, contributions or increased benefits by December 31, 2025.
The comment period for the proposed regulations officially closed on May 30, 2023, and the IRS and Treasury ultimately should issue final regulations. In the interim, defined contribution plan sponsors should review their plan forfeiture administration and plan documents and, if needed, consider amending them for forfeiture use consistent with proposed regulations. Both defined contribution and defined benefit plan sponsors should seek input from legal advisors as to any plan amendments needed to reflect final regulations.