IRS reverses position: Using forfeitures in Safe Harbor Plans
One technique that employers have used to “pass” the specific testing required for 401(k) plans is to design the plan as a “Safe Harbor 401(k)” Plan. A Safe Harbor Plan is deemed to automatically satisfy the testing. A Safe Harbor 401(k) Plan is a 401(k) plan that either provides every participant who is eligible to make a 401(k) salary deferral contribution with a 3 percent of compensation contribution (Non-elective Contribution Safe Harbor) or a matching contribution of 100 percent of deferrals up to 3 percent of compensation and 50 percent of deferrals on the next 2 percent of compensation (Matching Safe Harbor). Both the Non-elective Contribution Safe Harbor and the Matching Safe Harbor are required to be 100 percent vested and have the same distribution restrictions applicable to 401(k) deferral contributions.
Many Safe Harbor 401(k) Plans also include provisions for additional employer contributions. These additional contributions are not required to be 100 percent vested, but could be subject to the otherwise permitted vesting schedules. Accordingly, these additional contributions could and do generate forfeitures.
Every plan has to describe how forfeitures are to be used. Typically, forfeitures are used to pay expenses, are allocated to participants’ accounts using an allocation formula and very frequently used to offset employer contributions.
The IRS had taken the position that forfeitures could not be used to satisfy an employer’s Safe Harbor Contribution obligation. The IRS went so far as to require pre-approved plan documents to include language prohibiting the use of forfeitures for Safe Harbor Contributions.
However, in proposed regulations issued January 18, 2017, the IRS will permit Safe Harbor 401(k) Plans to use forfeitures to satisfy an employer’s Safe Harbor contribution obligation. Even though the regulations are only proposed, the IRS has indicated employers may rely on them currently, even before the adoption of the final regulations.
This is good news in that it provides employers with a use of forfeitures that can reduce what otherwise might be needed as a contribution.
All that said, there is the issue of how to operate a plan when the plan specifically states that forfeitures may not be used to offset Safe Harbor Contributions. Without an amendment authorizing the use of forfeitures for that purpose an employer runs the risk of failing to follow the terms of the plan. Employers are best advised to amend their plans accordingly to give themselves that option.
When an employer is using a pre-approved plan document that specifically prohibits the use of forfeitures for such purposes, amending the plan to do so is not so simple. Preapproved plans only permit a limited number of provisions that an employer may amend. Further, making such an amendment may eliminate the ability of the employer to rely on the determination letter issued to the pre-approved document sponsor.
We anticipate such sponsors will be examining how they can provide that flexibility to the employers using their pre-approved documents. How and when they will do that has yet to be seen.
Nevertheless, the proposed amendment to the IRS Regulations is a welcome development.
If you have questions, please contact any of the members of the McDonald Hopkins Employee Benefits Practice Group.