What Is a 401(k) Forfeiture and What Are the Rules?

Understanding 401(k) Forfeitures

A 401(k) plan is a retirement savings vehicle offered by many employers, allowing employees to save for retirement on a tax-advantaged basis. These plans enable participants to contribute a portion of their pre-tax paycheck directly into an investment account. Employers often enhance these plans by making contributions on behalf of their employees, such as matching contributions or profit-sharing allocations.

While employee contributions are always immediately and fully owned by the employee, employer contributions operate differently. Forfeiture in a 401(k) plan refers to the portion of employer contributions an employee loses if their employment ends before meeting specific service requirements. This occurs when an employee separates from service before satisfying the plan’s vesting schedule, meaning they do not gain full ownership of those employer-provided funds. This mechanism incentivizes employee retention.

Vesting Schedules and Their Impact

Vesting schedules determine when an employee gains full ownership of employer contributions to their 401(k) account. These schedules encourage employees to commit to a certain period of service. The two primary types are cliff vesting and graded vesting.

Under a cliff vesting schedule, an employee becomes 100% vested in employer contributions all at once after completing a specific number of years of service. For example, a common cliff schedule is three years. If an employee leaves before three years, they forfeit all employer contributions; upon reaching three years, they gain full ownership.

Graded vesting allows an employee to gradually gain ownership of employer contributions over a period of years. For instance, an employee might become 20% vested after two years, with an additional 20% vesting each subsequent year, reaching 100% after six years. If an employee departs after four years under this schedule, they would retain 60% of the employer contributions and forfeit the remaining 40%.

The maximum vesting period for employer matching contributions is three years for cliff vesting and six years for graded vesting, as stipulated by the Internal Revenue Service (IRS) and the Employee Retirement Income Security Act (ERISA). Profit-sharing contributions may have slightly longer maximum vesting periods.

Permitted Uses of Forfeited Funds

Once funds are forfeited from an employee’s 401(k) account, the plan sponsor, typically the employer, is permitted to use these funds in specific ways as regulated by the IRS and Department of Labor. Forfeited amounts cannot revert to the employer for their general business use or profit. Instead, these funds must remain within the 401(k) plan and be used for the exclusive benefit of the plan’s participants and beneficiaries.

One of the most common uses for forfeited funds is to reduce future employer contributions to the plan. An employer might use these funds to offset the amount they would otherwise contribute as matching contributions or profit-sharing allocations in subsequent plan years. This effectively lowers the employer’s cash outlay for plan contributions while still fulfilling their commitment to plan participants. This method is often preferred as it directly benefits the plan’s funding.

Forfeited funds can also be utilized to pay for reasonable and necessary administrative expenses of the 401(k) plan. These expenses might include fees for recordkeeping, trustee services, legal counsel, or auditor fees that are directly related to the operation and management of the plan. Using forfeited funds for these purposes can help reduce the overall cost of maintaining the plan, which can indirectly benefit participants by potentially allowing for higher contributions or lower participant fees.

A third permissible use for forfeited funds is to restore previously forfeited accounts for re-hired employees. If a former employee returns to the company within a certain timeframe, typically five years as per IRS regulations, and repays any cash-out distribution they received, the plan may use forfeited funds to reinstate their prior non-vested account balance. This provision encourages re-employment and ensures that employees do not permanently lose their non-vested benefits if they return to service. The plan document dictates the specific rules and timeframes for such restorations.