The Problem with Using Forfeitures to Satisfy Employer Contributions
Posted on May 8, 2017 by Legacy Retirement Solutions
Many tax-qualified, defined contribution retirement plans have provisions that allow the sponsor of such plan to fund profit sharing or, in the case of a 401(k) plan, matching contributions for the benefit of its participants. As a condition of receiving these employer contributions, many sponsors also impose a vesting schedule on such amounts. This has the effect of permissibly forcing a participant to work for some minimum period of time before he or she has a full and non-forfeitable right to such amounts. If a participant fails to satisfy this minimum period of employment, he or she may forfeit some or all of his or her employer funded benefit. When “forfeitures” occur, they are then generally available to the sponsor for the purpose of funding additional employer contributions to the participants of such plan or paying certain plan related administrative expenses. The remainder of this article discusses a newly proposed Internal Revenue Service (“IRS”) rule that brings a welcome expansion to the permissible uses of forfeitures to fund employer contributions.
Unless you are intimately familiar with the nuts and bolts of a 401(k) plan and its operation, you might not have heard of qualified nonelective contributions (“QNEC(s)”) and qualified matching contributions (“QMAC(s)”) before. QNECs and QMACs are special employer contributions that, among other things, are used to fund 401(k) safe harbor contributions and that also can be used to correct failures of the “average deferral percentage” (“ADP”) and “actual contribution percentage” (“ACP”) tests (the tests that limit the amount of “elective deferrals” and “employer matching” contribution that can be received by plan participants during a plan year). The attributes of QNECs and QMACs that make them special are that they must be one hundred percent fully vested and subject to distribution restrictions that are similar to elective deferrals such as not being distributable “in-service” prior to the attainment of age 59-1/2.
Prior to the release of the newly proposed regulations, restrictive IRS rules indicated that QNECs and QMACs must satisfy their “special” requirements (e.g., full vesting and elective deferral like distribution restrictions) at the time that such amounts were initially contributed to the trust of the plan receiving them. This was the rule despite the fact that a forfeiture used to fund a QNEC or QMAC could easily become fully vested and subject to the necessary distribution restrictions at the time that such forfeiture was allocated from the plan’s forfeiture account to the account of an individual participant as a QNEC or QMAC. In this context, the prior IRS requirement made little sense because it meant that, since forfeitures resulted from an employer contribution not being one hundred percent fully vested at the time of contribution to the plan, such forfeitures could not be used to fund QNECs or QMACs. This, in turn, would force plan sponsors to make additional contributions to its plan to fund safe harbor 401(k) and certain ADP and ACP corrective contributions even though the plan at issue had forfeitures that were otherwise available to fund such contributions.
Many industry practitioners routinely and repeatedly questioned the IRS regarding the logic behind the creation of this distinction between which types of employer contributions could permissibly be funded with forfeitures. In response, the IRS reconsidered the matter and promulgated a proposed regulation earlier this year that permits QNECs and QMACs to satisfy their special vesting and distribution requirements when such amounts are allocated to participants accounts as opposed to when such amounts are initially contributed to the trust of the plan. Thus, due to the IRS also granting the ability to immediately rely on the newly proposed regulation, plan sponsors will now be permitted to use forfeitures to fund the QNECs and QMACs that satisfy their 401(k) safe harbor as well as certain ADP and ACP corrective contribution obligations.
The IRS change discussed above resolves the regulatory prohibition on using forfeitures to fund QNECs and QMACs. However, it does not mean that every plan sponsor is immediately able to take advantage of this rule change. This is because the IRS previously required that most retirement plan documents include specific language that prohibits the utilization of forfeitures to fund QNECs and QMACs. Thus, most plan sponsors must also amend their retirement plan documents in order to remove this specific prohibition from the terms of its plan document before taking advantage of this relaxation of the regulations in connection with QNECs and QMACs.
Notwithstanding the foregoing, we are pleased to inform all plan sponsors that rely on Legacy Retirement Solutions, LLC (“Legacy”) for plan document services that Legacy has, on your behalf, already taken unilateral action to adopt the plan amendment necessary to allow QNECs and QMACs to be funded with forfeitures. Thus, going forward, both the regulatory and plan document provisions that would otherwise prohibit funding QNECs and QMACs from forfeitures have already been removed with respect to Legacy retirement plan document clients. In addition, please be advised that Legacy retirement plan document clients will receive copies of such amendment in the immediate future so that a copy of this amendment can be independently maintained in your retirement plan files.
As much as we hope this article helped you to better understand this topic, it is not to be construed as financial, tax or legal advice. Therefore, if you believe that the issues discussed herein may apply to your (or your client’s) company, be sure to further discuss it with a qualified retirement plan professional. For more information about this topic, please contact our marketing department at 484-483-1044 or your administrator at Legacy.