IRS Proposes to Relax Rules Permitting Forfeitures to Fund 401(k) Plan Safe Harbor Contributions
The following report was published by IslerDare PC (www.IslerDare.com) and is republished here with their permission. Note: Mentions in this article of the IRS refer to the Internal Revenue System (IRS).
IRS Proposes to Relax Rules Permitting Forfeitures to Fund 401(k) Plan Safe Harbor Contributions and to Correct Operational and Nondiscrimination Test Failures
The IRS recently proposed regulations that would permit employers to use forfeiture accounts to fund or offset safe harbor contributions and to correct operational and nondiscrimination test failures. This represents an important relaxation of the IRS’s somewhat controversial position and, if finalized, would be a welcome change providing enhanced flexibility for employers.
What You Should Do
Consult with your vendors and review the terms of your 401(k) plan to determine if changes need to be made to your services agreement or plan document to allow you to use forfeitures to fund safe harbor contributions or to correct operational and nondiscrimination test failures, either now or when the proposed regulations are finalized.
In recent years, many employers have structured their 401(k) plans as “safe harbor” plans, which provide a certain level of employer non-elective contributions or matching contributions to satisfy nondiscrimination requirements. All safe harbor contributions, whether they are non-elective contributions or matching contributions, are fully vested and are subject to distribution limitations. It is also common for employers to correct 401(k) plan operational issues and nondiscrimination test failures by making corrective contributions that are fully vested and subject to distribution limitations.
When 401(k) plans also provide an additional source of contributions that are subject to vesting standards based on an employee’s years of service with the employer, those plans are likely to have funds that have been forfeited by terminating participants and that are held in unallocated “forfeiture accounts”. Because forfeitures are required to be used or allocated annually, most 401(k) plan documents provide that forfeitures can be used to reduce plan administrative expenses or reduce employer contributions, or can be allocated to participant accounts.
In recent years, the IRS has taken a very strict interpretation of its 401(k) regulations, stating that forfeited funds can be used only to fund or offset other employer contributions, such as discretionary or fixed contributions, and that they should not be used to fund or offset safe harbor contributions or corrective contributions. The IRS’s rationale is that any monies that are allocated to participants’ 401(k) plan accounts in these cases need to be subject to the full vesting requirements and distribution limitations associated with safe harbor contributions or corrective contributions at the time that those monies are contributed. Because funds held in the forfeiture accounts were not, by definition, fully vested and subject to the distribution limits that apply to safe harbor or corrective contributions at the time that they were contributed, many 401(k) plan documents and service agreements prohibit forfeitures from being used to fund or offset safe harbor contributions or corrective contributions.
On January 18, 2017, the IRS proposed changes to its 401(k) regulations that would allow employers to use forfeitures to fund or offset safe harbor contributions and to fund corrective contributions for operational issues or nondiscrimination test failures. Essentially, the proposed regulations would modify the timing of the full vesting requirements and distribution limitations associated with these contributions by permitting forfeiture monies to be used to fund or offset these contributions as long as those monies are treated as fully vested and subject to the necessary distribution limitations at the time that they are allocated to participant accounts. The proposed changes give employers additional flexibility and could ease cash-flow requirements, because safe harbor contributions and corrective contributions would no longer need to be limited to new contributions.
At this juncture, the proposed changes are just that—proposed, not finalized—and it is not clear when the approval process to finalize them might begin, due to the transition of President Trump’s administration.
Specifically, on January 20, 2017, White House Chief of Staff Reince Priebus issued a memorandum to all federal agencies freezing the regulatory review process and imposing a 60-day delay on all regulations by the new administration. If, after this delay, the proposed changes continue to go through the regulatory process, the rules would take effect for taxable years beginning on or after the date on which they are finalized (i.e., no earlier than January 1, 2018 for calendar year plans, if they were to be finalized sometime in 2017). However, the IRS helpfully stated that taxpayers are permitted to rely on the proposed regulations for earlier periods, which is welcome news for employers and provides additional flexibility to use forfeitures now, provided that doing so is consistent with all relevant 401(k) plan documents and services agreements (or that appropriate amendments to those documents are made to permit the use of forfeitures consistent with the proposed regulations).