What is a Forfeiture Account?
When an employee leaves a company and has an unvested portion of money in the company’s defined contribution retirement plan (such as a 401(k)), the employee forfeits those funds which he is not vested in, thereby creating a “Forfeiture”. The nonvested funds (“Forfeitures”) are collected in what’s known as a forfeiture account. The forfeiture account serves as a temporary holding place until the Forfeitures can be used in accordance with the terms of the Plan Document.
Forfeitures are allowed to be used to pay for certain administrative expenses incurred by the plan such as; auditing, accounting, or recordkeeping fees, or fees for annual administration and compliance services. The forfeiture funds can also be used to reduce certain employer contributions to the plan, or they can be reallocated back to the remaining eligible participants as an additional contribution. Ultimately, the terms of the plan document govern how the forfeitures are used and the deadline or the Plan Year for using them. Typically, these forfeitures should be used or allocated during the plan year in which the forfeiture occurred and should not be carried over into subsequent years. However, specific language in the plan document can allow for the forfeitures to be distributed the year following the year in which the forfeitures occur.
Example: Joan has a 401(k) balance of $10,000. $5,000 of that account balance is contributions her employer made to her account, the other $5,000 is what Joan contributed from her paycheck. At the time of her termination, she is 60% vested in the employer contributions portion of her account. This means Joan will receive $8,000 of her $10,000 account balance and $2,000 will be forfeited.
Employer contribution $5,000 X 60%= $3,000 Employee contribution $5,000 Employer + Employee contribution= $3,000 + $5,000= $8,000
For additional information about forfeiture accounts, please don’t hesitate to give us a call. You can also reference Revenue Ruling 84-156 and Treasury Regulations Section 1.401-7(a).