The U.S. Qualified Plan Forfeiture Regulation Gets a Makeover for Its 60th Anniversary

On February 27, 2023, the U.S. Internal Revenue Service (IRS) issued proposed rules (the Proposed Rule) for how and when to use forfeitures in qualified retirement plans. This is welcome news for plan administrators, as previously the IRS offered little formal or consistent guidance on this topic.

The Proposed Rule provides guidance on how both defined benefit plans and defined contribution plans should treat forfeitures.

Defined contribution plans

The permissible use of forfeitures in defined contribution plans has been regulated by piecemeal guidance that complicates the job of many plan administrators. The clearest guidance came in a 2010 IRS newsletter, which said that (1) forfeitures could be allocated to participants’ accounts, used to pay for a plan’s administrative expenses, or used to reduce employer contributions, and (2) all forfeitures must be used by the end of the plan year in which they arise.

The new proposed regulation provides that defined contribution plans must follow two rules: (1) Forfeitures can be used only to pay plan administrative expenses, to reduce employer contributions under the plan, or to increase benefits in other participants’ accounts in accordance with plan terms (generally the same as the 2010 guidance), and (2) all forfeitures must be used during or within 12 months after the end of the plan year in which they arose. This new timing rule is much less burdensome than the prior guidance, especially for forfeitures that occur near the end of the plan year.

Defined benefit plans

Internal Revenue Code §401(a)(8) currently provides that for defined benefit plans, “forfeitures must not be applied to increase the benefits any employee would otherwise receive under the plan.” Current Treasury Reg § 1.401-7 also requires that defined benefit plans must use these forfeitures “as soon as possible” and must use them to “reduce the employer’s contributions under the plan.” However, this regulation has not been amended since 1963 and is contrary to the now longstanding minimum funding standards, which do not allow the use of forfeitures to reduce required employer contributions to a defined benefit plan.

For defined benefit plans, the new Proposed Rule provides that plan documents must expressly include the Internal Revenue Code requirement that forfeitures may not be applied to increase benefits under the plan. In addition, instead of requiring plans to use the forfeitures as soon as possible to reduce the employer’s contributions, the Proposed Rule contemplates that anticipated forfeitures should be used in determining plan liabilities, thus indirectly affecting future employer contributions required to satisfy the minimum funding requirements.

Effective Date

The Proposed Rule would apply to forfeitures incurred in plan years beginning on or after January 1, 2024. Any forfeitures incurred before then would be treated as arising in the first plan year beginning on or after January 1, 2024. However, taxpayers may rely on the Proposed Rule prior to the effective date.

Knowledge Management Lawyer Katie Dean contributed to this Sidley Update.