How to Record 401k Forfeitures in Accounting

A 401(k) plan is an employer-sponsored retirement savings vehicle where employees contribute pre-tax salary and employers often provide matching or profit-sharing contributions. Employer contributions do not always immediately belong to the employee; a vesting schedule determines when an employee gains full ownership. When an employee leaves before employer contributions are fully vested, the unvested portion returns to the plan as a “forfeiture.” Accounting for these forfeitures is necessary for plan sponsors to ensure compliance and maintain accurate financial records.

Understanding 401(k) Forfeitures

Forfeitures are the unvested portion of employer contributions an employee loses when leaving a company before meeting vesting requirements. Employee contributions are always 100% vested, but employer contributions, like matching funds or profit-sharing, are subject to a vesting schedule. These schedules encourage employee retention, as full ownership depends on continued service.

Two common vesting schedules are cliff vesting and graded vesting. Cliff vesting grants 100% ownership of employer contributions all at once after a specified period, typically three years. If an employee leaves before this period, they forfeit all unvested employer contributions.

Graded vesting allows employees to gradually vest over two to six years, with increasing percentages of ownership each year. For example, a graded schedule might vest 20% after two years, 40% after three, and reach 100% after six years.

Forfeitures occur when an employee terminates employment and receives a vested balance distribution, or incurs five consecutive one-year breaks in service. The non-vested amount transfers to a forfeiture account within the 401(k) plan. These forfeited amounts remain plan assets, not company assets, and must be used solely for the benefit of plan participants and beneficiaries.

Permitted Uses of Forfeitures

Forfeitures cannot revert to the employer for general business purposes. They must be used for specific, permissible purposes benefiting the plan or its participants, as outlined in the plan document and adhering to IRS and ERISA regulations.

One common use is to reduce future employer contributions. The employer can use the forfeiture balance to offset matching or profit-sharing contributions, reducing cash outflow. For instance, if an employer plans to contribute $10,000 and has $2,000 in forfeitures, they could remit $8,000 in cash and use the $2,000 from the forfeiture account to meet the total contribution. This lowers the employer’s out-of-pocket costs while fulfilling plan contribution commitments.

Another use for forfeitures is to pay reasonable administrative expenses of the 401(k) plan. These include recordkeeping, trustee, and audit fees, and other costs related to plan operation. Using forfeitures for these expenses ensures participants do not bear these costs directly. Plan documents specify covered expenses. Forfeitures can also allocate additional contributions to participants or restore previously forfeited accounts of re-hired employees.

Recording Forfeiture Transactions

Recording 401(k) forfeitures requires specific journal entries on the company’s financial books. When an employee terminates and their unvested employer contributions are forfeited, the initial entry recognizes this event. If contributions were recorded as an accrued liability, the forfeiture reduces this liability.

To recognize a forfeiture, an employer debits “Accrued 401(k) Contribution Liability” or “401(k) Contribution Expense” and credits a “401(k) Forfeiture Account.” For example, if $1,000 is forfeited:
Debit: Accrued 401(k) Contribution Liability $1,000
Credit: 401(k) Forfeiture Account $1,000
This entry moves the unvested portion from a liability or expense into a separate account representing the pool of available forfeitures.

When forfeitures reduce future employer contributions, a different entry is made. This reduces the employer’s cash outlay for contributions. For instance, if $500 from the forfeiture account offsets a $5,000 employer contribution, the employer pays $4,500 in cash. The entry is:
Debit: 401(k) Contribution Expense $500
Credit: 401(k) Forfeiture Account $500
This entry uses forfeited funds to satisfy a portion of the current period’s contribution obligation, reducing new cash needed.

If forfeitures pay for plan administrative expenses, the journal entry reflects payment from the forfeiture pool, not company operating funds. For example, if $300 in administrative fees are paid using forfeitures:
Debit: 401(k) Administrative Expense $300
Credit: 401(k) Forfeiture Account $300
This entry recognizes the expense, with the forfeiture account as the source. Forfeitures are recognized when they occur, and their use is recorded when applied.

Tracking and Reporting Forfeitures

Maintaining accurate internal records for 401(k) forfeitures supports compliance and financial management. Plan sponsors should track the forfeiture account balance, ensuring funds are used according to the plan document and regulatory requirements. This often involves a separate ledger or sub-account for precise monitoring. Regular reconciliation with recordkeeper statements helps identify discrepancies.

Timely utilization is a key aspect of managing forfeitures. The IRS requires forfeitures be used no later than 12 months after the close of the plan year in which they occurred. For example, a 2024 forfeiture must be used by December 31, 2025, for a calendar year plan. Failure to use forfeitures within this timeframe can lead to operational failures and penalties. Recent IRS proposed regulations, effective for plan years beginning on or after January 1, 2024, reinforce this deadline and provide a transition rule for existing accumulated forfeitures, treating them as if incurred in 2024 to be used by the end of 2025.

Forfeiture balances and usage have external reporting implications, primarily for the annual Form 5500 filing. This form, required by the IRS and Department of Labor (DOL), reports 401(k) plan financial activities, assets, and compliance. Forfeiture accounts are reflected in the plan’s financial statements included in the filing. Managing forfeitures correctly falls under the plan sponsor’s fiduciary responsibilities, requiring them to act in the best interest of plan participants.