In recent years, forfeitures in qualified retirement plans have moved from a routine administrative matter to a focal point of regulatory scrutiny and litigation. Proposed regulations in 2023 from the Internal Revenue Service (IRS) clarified how forfeitures must be used, but a wave of lawsuits in 2024 and 2025 has exposed a new layer of fiduciary risk for plan sponsors, despite remaining in alignment with plan documents. Amidst the regulatory scrutiny, plan sponsors must not only maintain compliance with IRS rules but also anticipate how courts and the Department of Labor (DOL) may interpret fiduciary obligations under ERISA.
What Are Forfeitures?
Forfeitures occur when a participant in a defined contribution plan leaves their place of employment before becoming fully vested in employer contributions. The nonvested portion of their account is thereby forfeited back into the plan and becomes a plan asset. Depending on the plan document, such funds can be used in several ways, for example:
- To pay plan administrative expenses
- To reduce or offset future employer contributions
- To reallocate to active participants’ accounts
The IRS’s 2023 proposed regulations formalized long-standing informal guidance and introduced a critical timing rule: forfeitures must be used no later than 12 months after the close of the plan year in which they occur.
The Rise of Litigation: Fiduciary Risk in Focus
Despite efforts to align with plan documents, plan sponsors find themselves facing lawsuits over how forfeitures are used. Since the fall of 2023, more than 30 class action suits were filed challenging the use of forfeitures to offset employer contributions. Plaintiffs argue that this practice violates ERISA’s fiduciary standards, particularly the duty to act solely in the interest of plan participants.
The legal theory hinges on whether using forfeitures to offset or reduce employer contributions, rather than paying plan expenses, constitutes self-dealing or a breach of fiduciary duty. Courts have so far issued mixed rulings, with some finding no violation and others suggesting that discretion in forfeiture use may be subject to fiduciary scrutiny.
The DOL has yet to issue formal guidance, but a 2023 enforcement action against Sypris Solutions Inc. hinted at a stricter interpretation. The DOL alleged that using forfeitures to reduce employer contributions, when plan documents required them to be used for expenses, was benefitting the employer and harmful to participants.
Best Practices for Plan Sponsors
Given the dual compliance requirements under the Internal Revenue Code and ERISA, plan sponsors should adopt a proactive approach to forfeiture management. Here are key best practices:
- Review and Update Plan Documents: Your plan document must clearly outline all permissible uses of forfeitures. Limiting forfeiture use to a single purpose (e.g., only paying expenses) could lead to operational violations if forfeitures exceed that need.
- Use Forfeitures Timely: The IRS requires forfeitures to be used within 12 months of the end of the plan year in which they occur, or your plan could face audit issues or risk disqualification.
- Take Advantage of the Transition Rule: Forfeitures incurred before 2024 can be treated as incurred in the first plan year beginning on or after Jan. 1, 2024, which provides sponsors time until the end of 2025 to use up prior forfeitures and correct any past operational failures.
- Document Fiduciary Decisions: If your plan gives fiduciaries discretion in how forfeitures are used, document the rationale behind each decision. Courts may scrutinize whether fiduciaries acted in participants’ best interests, especially when choosing between reducing employer contributions and paying plan expenses.
- Coordinate with Recordkeepers and Advisors: Your recordkeeper should fully understand the plan’s forfeiture provisions and timing requirements. Regular communication can help avoid missteps and ensure forfeitures are used appropriately.
Windham Brannon Can Help with Plan Forfeitures
Even though the IRS has issued guidelines and clarity on timing and usage of forfeitures, ERISA litigation is testing the boundaries of fiduciary discretion. Plan sponsors should therefore work to balance operational compliance with a heightened awareness of fiduciary obligations. Windham Brannon’s Employee Benefit Plan Audit professionals are well-versed in ERISA requirements and can help you make informed business decisions regarding forfeiture usage as it relates to your plan. For more information or questions, reach out to Anne Morris, Employee Benefit Plan Audit Practice Leader.
