Using Forfeitures In Defined Contribution Plans

As seen in our 2023 EOY Newsletter: Click Here

 by: Aaron Epstein, QKA

The term “forfeiture” refers to the non-vested portion of a former employee’s account balance in the plan. For example, if a participant is 40% vested in their profit sharing account source when they terminate, the remaining 60% of his profit-sharing account balance will become a forfeiture.

Plan sponsors can use forfeitures in defined contribution plans to take any of the following three actions:

1. Reduce employer contributions Under this option, the forfeitures offset a portion of the contribution the employer would otherwise make under the plan. For example, assume a company has a forfeiture account balance of $3,000. The company decides to make a profit-sharing contribution of 10% of compensation for the year, which equals $35,000. In this case, the company could deposit $32,000 toward the contribution from employer general funds and use the $3,000 in the forfeiture account to bring the total contribution allocation to $35,000.

2. Enhance employer contributions A plan may use forfeitures to provide additional allocations for participants. Under this option, the forfeiture allocated represents an increase to the contribution the employer would otherwise make under the plan. In the example above, if the company’s target profit sharing contribution was $35,000, and they had $3,000 in the forfeiture account, the company could deposit $35,000 toward the contribution from employer general funds and use the $3,000 in the forfeiture account to provide an enhanced profit-sharing contribution of $38,000.

 3. Payment of plan-related administrative expenses A plan may provide for the use of forfeitures to first pay reasonable administrative expenses. To the extent forfeitures exceed the amount required to pay expenses, the excess could be used to reduce or enhance employer contributions.

Most defined contribution plan documents include language authorizing all 3 forfeiture uses described above.

In April 2023, the IRS released proposed regulations on forfeiture accounts, including timing for the use of forfeitures. In these proposed regulations, the IRS re-emphasized the existing rule that a plan must use forfeitures no later than 12 months after the close of the plan year in which the forfeiture occurred. For example, if a forfeiture occurs in a calendar year plan in 2024, the forfeiture would have to be used to reduce employer contributions, enhance employer contributions, or pay plan expenses by 12/31/2025.

The proposed regulation has formalized this timing requirement. The proposed regulation also provides for a transition rule. Under the transition rule, any forfeitures that were incurred in any plan year beginning before 2024 are treated as having been incurred in the first plan year that begins on or after 01/01/2024, and must be used no later than 12/31/2025 for a calendar year plan.

In summary, plan sponsors should review their plan document to confirm that it provides for the 3 allowable options regarding how forfeitures may be used. If the document does not currently include all 3 options, it can be amended. Plan sponsors should make sure that the timing of forfeiture use is in compliance with regulations. They can take advantage of the transition rules to utilize any forfeitures incurred prior to 2024 by the end of the 2025 plan year.

Now that the IRS has formalized the timing requirements for forfeiture use, it stands to reason that they are less likely to be forgiving of violations of this requirement. 

 

READY OR NOT—LONG TERM PART TIME IS HERE

Readers of our newsletter, or almost any retirement plan-related news over the last few years will have heard talk about the long-term part-time (LTPT) rules, which were added to the law by the SECURE Act back in 2019. We’ve been through a global pandemic, multiple pieces of legislation and regulations, and countless other events since then, but on January 1, 2024, many plans could see their first employees becoming eligible under this rule.

The Froth Over Roth - September 2023 Newsletter

By: Lawrence J. Zeller, MSEA

What are Roth contributions?

Traditionally, contributions to an IRA or 401(k) plan are tax-deductible when made, and taxable when withdrawn in retirement. Roth contributions1 on the other hand, are taxable in the year when they are made, but can be withdrawn tax-free during retirement. As long as certain requirements are met, both the contributions and earnings in a Roth account are non-taxable when withdrawn.

What conditions must be met for Roth 401(k) distributions to be tax-free?

In order to avoid paying taxes on Roth account withdrawals, the Roth account must have been established at least 5 years ago. There are complex rules regarding this 5-year “clock,” but in most cases the rule is that the 5-year period begins on the first day of the year in which you make the first Roth contribution to the account. So, for example, if your first contribution was made on December 30th, 2021, the clock starts on January 1, 2021 and you would be eligible to make tax-free withdrawals beginning on January 1, 2026, even though that’s only 4 years and 2 days after the actual contribution. In addition to meeting the 5-year rule, the participant must be at least age 59½ at the date of distribution 2.

Why have Roth 401(k) contributions been in the news lately?

The SECURE 2.0 Act 3 added a provision that requires catch-up contributions 4 to be made on a Roth basis for individuals with more than $145,000 in wages 5 in the previous year (indexed). Originally, this provision was set to be effective January 1, 2024. But the new rule gave rise to many complicated questions and logistical issues. Pension practitioners, professional retirement plan organizations, and payroll companies explained to the government why more time was necessary before this provision becomes effective. On August 25, 2023, the IRS and the Treasury Department announced that enforcement of the Roth catch-up mandate would be delayed until January 1, 2026. This was a big relief!

Must all 401(k) plans offer Roth contributions?

No, many 401(k) plans do not offer Roth contributions. But if a plan does offer Roth, then all participants must be allowed to elect whether to make Roth contributions or stick with traditional (tax-deductible) treatment for all or part of their contributions. The same is true regarding catch-up contributions: if they are offered, all participants must be eligible to elect them. Therefore, beginning in 2026, with limited exceptions, if a 401(k) plan does not offer Roth contributions, then participants will not be able to make catch-up contributions.

So, does it make sense to make traditional 401(k) contributions or Roth 401(k) contributions?

Ah, this is the big question, and of course the answer is “it depends.” If the goal is to minimize the total amount of taxes paid, then it helps to consider whether you’re likely to be in a higher tax bracket when you make the contribution or when you receive the distribution from the account. In general, if you’re in a higher tax bracket when you make the contribution, traditional is favored; if you’ll be in a higher tax bracket when you receive the distribution, Roth is favored. But there are a lot of exceptions to this rule, and it depends on the specifics of your situation. Here are a few examples of different situations that favor one type of contribution or another.

I’m just starting my career and want to start saving for retirement early!

You would generally favor Roth, since you are likely to be in a lower tax bracket now

than you will be later in your career.

I want to save the largest possible amount for retirement.

You would generally favor Roth, since you are effectively pre-paying the taxes on your

retirement savings.

I want to put some money aside for retirement, but I am worried about the impact on my current finances.

You would generally favor traditional in order to minimize the impact on your paycheck.

Traditional contributions aren’t subject to income tax withholding, so for example a $500

contribution might only result in a $350 reduction in your paycheck.

I am in the later part of my career and have high earnings. I am considering retiring in the near future, and expect to fall into a lower tax bracket.

You would generally favor traditional contributions. You should take the tax deduction

now while in a higher tax bracket and pay taxes later at a lower bracket. This also

avoids having to meet the 5-year rule in case funds are needed before the end of the 5

years.

I want to maximize the amount I leave for my heirs.

You would generally favor Roth. That’s because traditional accounts are subject to

something called the Required Minimum Distributions (RMD) rule, meaning that a

certain percentage must be taken out of the account each year starting at a certain age.

Starting in 2024, RMDs will no longer be required from Roth 401(k) accounts while you

are still alive.

There are many more situations than the five shown above. In addition, more than one of these situations can apply at the same time, some favoring traditional, some favoring Roth. You should consult with your tax advisor about what’s best for you.

1 Income limitations may restrict the ability to make Roth IRA contributions. This article deals mostly with Roth 401(k) accounts.

2 Withdrawals can also be made if the participant dies or becomes totally disabled (under the Social Security definition of total disability)

3 For more information about SECURE 2.0, see https://www.preferredpension.com/news/2023/1/17/secure-20-act

4 https://www.investopedia.com/401k-catch-up-contributions-5499024

5 This is defined as wages for FICA (e.g. Social Security) from the employer sponsoring the 401(k) plan. If you have wages from more than one unrelated employer, or wages not subject to FICA, then this limit will apply separately to each employer’s wages, or not at all.