Use of forfeitures to fund elective contributions and loan repayments in 401(k) plan

[Luke Bailey]

Assume that a 401(k) plan with matching and/or profit sharing subject to vesting has a cash-out and buyback provision and language in the plan document that says that forfeiture of nonvested portion of account occurs immediately following the participant's taking a lump sum distribution of vested portion. Assume plan document also says that forfeitures can be used to pay admin expenses and that any amount not used to pay admin expenses may be used to offset "any payments that the employer would otherwise be required to make to the plan." Could the employer not transfer to the plan amounts withheld from employees' pay as elective 401(k) contributions and loan repayments and credit to the accounts of the affected employees instead amounts pulled from current forfeitures? Assume that the crediting of the previously forfeited amounts would be at least as rapid as if the withheld amounts were transferred to the plan and credited to the affected employees' accounts and that the time period would pass the DOL's requirements.

[My 2 cents]

Maybe I don't fully understand your question, but I think the answer has to be that loan repayments cannot be part of anything to do with forfeitures.  I don't work on 401(k) plans, but the following would be my understanding (but it could be that they are not accurate):

1.  It is impossible to characterize loan repayments as having anything to do with "payments that the employer would otherwise have to make to the plan".  They are loan repayments,  and have to be made by the participants who took the loans.

2.  Loan repayments cannot be "forfeited", since loans can only be taken from vested funds.

[Luke Bailey]

So, here again is the question, expressed more concretely. Suppose that during the first part of 2017 terminated employees who were partially vested and have taken lump sums have forfeited, in the aggregate, $100,000, and that under the plan's rules those forfeitures are available to be used to offset admin expenses and contributions that would otherwise need to be made by the employer. Let's assume that the employer prefers to pay the plan admin expenses itself, directly, so that none of the $100,000 in forfeitures will be used for admin expenses. Now suppose that for the payroll period that will end September 29, 2017, the employer will, pursuant to employees' elective deferral agreements, withhold $20,000 in employee elective deferrals, $5,000 in employee 401(k) loan repayments, and will need to make matching contributions of $4,000. So the employer will, without taking into account the forfeitures, have to transfer $29,000 to the plan on or very shortly after September 29, 2017. We know that the employer can, if it chooses, transfer only $25,000 to the plan and use $4,000 of the $100,000 in forfeitures to fund its match. But assuming that plan language is not a problem (which it probably would be for most plans, but let's assume it's not, or could be changed) and also that the employer could move the $25,000 in forfeitures into participants accounts immediately (e.g., the money would be in the accounts as of close of business on September 29, 2017), can the employer choose not to transfer any funds to the plan at all on September 29, 2017, and just use $29,000 out of the $100,000 in forfeitures to fund the required allocations to participants' accounts for elective deferrals and loan repayments, as well as muatching, reducing the forfeiture account to $71,000?

[Belgarath]

I'd say no. See 1.401(k)-1(a)(3)(iii)(C).

[401_noob]

My DC 1 book says that funding deferrals with forfeitures is not permitted.

Forfeitures used to reduce elective contributions- Treasury regulations also prohibit the contribution of elective contributions made on behalf of an employee before the employee performs the services to which the elective contributions relate (or before the compensation would have otherwise become currently available had the deferral election not been made). While an exception is made for forfeitures applied to matching contributions, no exception is made for forfeitures that are allocated to satisfy the employer's contribution obligation with respect to elective contributions. Thus, the allocation of a forfeiture to another employee's account to satisfy the employer's obligation to contribute to the employee's elective contributions would be in violation of the regulations.  

The text cites the same thing Belgarath cited. 

[Luke Bailey]

I think I'll advise the client not to do it, but I also think the reg cited is thin support at best for the position. 1.401(k)-1(a)(3)(iii)(C) deals with whether there is a good "cash or deferred" election. Certainly, from the employee's perspective, he or she has made a good cash or deferred election, and his or her contributions were not withheld, and no amount was allocated to his or her account, before the services were performed.

This reg provision may be target at preventing employers from anticipating 401(k) contributions at end of year to accelerate deductions, but the opposite would be achieved here, since if anything using the forfeitures will defer the deduction.

Thanks for your responses. I really appreciate them

[My 2 cents]

I reiterate, based on my understanding, such as it is, (using the numbers from the example above) that the $5,000 amount withheld from pay to repay plan loans does not count as a salary reduction amount, does not represent an amount paid by the employer, is not pre-tax etc. Under no circumstances (based on my understanding) can the forfeitures be used for loan repayments. 

I don't know whether forfeitures can be used to cover salary reduction amounts.  Maybe matches, certainly expenses that would otherwise be borne by the employer.  Remember, the default use for forfeitures is to increase amounts paid into the accounts of the other participants. 

If the employer chooses to pay administrative expenses directly, it strikes me as reasonable and appropriate that the $100,000 in forfeitures be reduced by those expenses before the remainder is allocated to the participant accounts.

[Luke Bailey]

You're right, there is a distinction on the loan amounts, but the point (or, at least, "a" point) is that in both cases, if the plan says that forfeitures reduce employer contributions, and contains no provision for ever reallocating them to employees, then the $100k in forfeitures, and any earnings on it while it is in suspense, is going to be used for the economic benefit of the employer over time. Notwithstanding that it is in the plan's trust, and a plan asset, economically it's in a pocket of the employer, so for the employer to take money out of that pocket to amortize the loans instead of from another of its pocket (i.e., its general assets as enriched temporarily by the employer's withholding of the loan repayments) doesn't seem to make a difference economically.

Think of it this way. Suppose I change the numbers. There are still $100,000 in forfeitures, and I have withheld from employees' pay $20,000 in elective deferrals, $5,000 in loan repayments, and I owe $4,000 in matching. Suppose it's April, 2018 and the employer also owes $96,000 as an end of year profit sharing for 2017. Between the $96,000 in profit sharing, $20,000 in deferrals, $4,000 in matching, and $5,000 in loan repayments, the trustee/recordkeeper, say a bank, needs to immediately allocate $125,000 to employees' accounts. The employer wires $25,000 to the bank/recordkeeper and instructs the bank/recordkeeper to use up all of the forfeitures to fund the rest of the required allocations. Money is fungible. How do we know that the $25,000 that gets wired is the deferrals and loan repayments vs. the match and some of the profit sharing? Economically, there's no difference. That's my only point. I'm not saying this is a good idea or that IRS or DOL would not be unhappy with it. I was just aking if there was a clear reg or ruling on point, and so far I haven't seen evidence there is.

[My 2 cents]

I don't work on defined contribution plans.  Generally, a defined benefit plan must provide that forfeitures cannot be used to increase individual benefits and must be used to reduce future employer contributions.  The rules on defined contribution plans are somewhat different.  Apparently, forfeitures can now be used to cover employer contributions other than those that are,  in reality, made by the participants through salary reduction agreements.  However one deals with forfeitures, it should be consistent with what the plan says.

Is there such a thing as a defined contribution plan that does not permit allocating forfeitures to individual accounts?  Reducing future employer contributions is inherently part of the funding method in a defined benefit plan, but reducing future employer contributions is harder to make work in a defined contribution plan setting. 

[duckthing]

2 hours ago, Luke Bailey said:

can the employer choose not to transfer any funds to the plan at all on September 29, 2017, and just use $29,000 out of the $100,000 in forfeitures to fund the required allocations to participants' accounts for elective deferrals and loan repayments, as well as muatching, reducing the forfeiture account to $71,000?

To make sure I'm following the example: what would they do with the $25,000 they withheld from employees' paychecks?

 

29 minutes ago, Luke Bailey said:

Notwithstanding that it is in the plan's trust, and a plan asset, economically it's in a pocket of the employer

I don't think you can notwithstand that away: the trust is not in any way a pocket of the employer.

[Luke Bailey]

I think if the plan says, which most do, something like "Forfeitures can be used to pay admin expenses or to offset otherwise-required employer contributions," then you would be violating your plan doc if you simply reallocated them. Of course, the employer could always resolve to make a discretionary employer contribution exactly equal to the forfeitures, which would have same economic effect. Note that the language I have put in quotes would probably be a bar to using forfeitures as an offset against requirement to transfer withheld elective deferrals and loan repayments. You would need to tweak the language if you wanted to do that.

[Luke Bailey]

Duckthing, re your first point, my point is that since the employer would have transferred $25k to the plan, in my somewhat artificial example the question of whether it actually transferred the $25k in withheld elective and loan repayments, or pocketed them, is metaphysical.

Re your second point, I think that is what it may come down to, especially with IRS and DOL. They would say that even though, absent a precipitous plan termination or employer bankruptcy or the like, the employees have exactly the same economics either way, it would be a "use of plan assets" to not deposit the deferrals and withheld loan amounts. So probably a PT issue more than plan qualification.

[Mike Preston]

It is a PT only if correctable and, at some point, corrected.  What you are describing comes closer to theft.

[QDROphile]

From the words on the page in the tax code and the regulations, use of forfeitures to fund elective contributions is OK;  elective contributions are employer contributions.  However, the IRS denies this when questioned.  Perhaps the reason the IRS denies this is that ERISA looks at elective contributions as employee contributions (unlike the tax code), so the employer can never retain the elective deferral amount  (see Mike Preston's comment about theft) even if the employee participant is credited under the plan with the amount, funded from forfeitures.  This is an example of an awkward reconciliation between the way the tax code rationalizes certain things and ERISA's different take on the same things.  The status of "pre-tax" elective deferrals as employer contributions under the tax code is artificial, but is consistent with the deductibility of the contributions (employer contributions are deductible) under general tax principles.  Contrast after-tax "employee contributions" that are not deductible.  ERISA sees all contributions from the employee's pocket or paycheck as employee contributions and does not indulge in the artificiality about elective deferrals being employer contributions because the employee did not receive the contributions.  ERISA is closer to our gut understanding of whose money is involved.   Treasury and DOL do not like to fight over differences even if they have to be intellectually dishonest.  Compare the "new" 403(b) regulations with the DOL's awkward attempt to preserve its  traditional position about what constitute employer involvement for purposes of determining if a plan is exempt form ERISA.

[ESOP Guy]

2 hours ago, My 2 cents said:

Is there such a thing as a defined contribution plan that does not permit allocating forfeitures to individual accounts?  Reducing future employer contributions is inherently part of the funding method in a defined benefit plan, but reducing future employer contributions is harder to make work in a defined contribution plan setting. 

Yes you could write a DC plan document that way.  In fact a very large number are that way.  The forfeitures simply reduce the cost to the employer. 

For example forfeitures are $13k and the Profit Sharing contribution (or match due) is $25k many plans would say the employer needs to only put in the remaining $12k.  Obviously the $13k of forfeitures plus the $12k deposit equal $25k.

But you could write the plan such that the employer puts in the full $25k and they employees get the $13k also. 

I am ignoring things like 415 for purposes of this discussion.

And to now give you more answer then you wanted you can write a DC plan to give the plan administrator all kinds of discretion.

It could give them the option to use the $13k above to pay fees or not, then reduce the employer's contribution for example. 

Lastly, the other thing forfeitures are used for in a DC plan that MIGHT like a DB plan is they are used to restore people who forfeiture in the past and if their balance needs to be restored upon rehire that almost always comes from current forfeiture.  Such a restore increases the benefits due in a DB plan so it needs to be funded and as you say all funding is forfeitures or contributions- ignoring earnings of this conversation. 

[RatherBeGolfing]

1 hour ago, ESOP Guy said:

And to now give you more answer then you wanted you can write a DC plan to give the plan administrator all kinds of discretion.

Yep.  Our document uses the "any permissible method" catchall for forfeitures.

[Belgarath]

Hi Luke - we'll agree to disagree on this. I don't think it is thin support at all. I think it is explicit. "Contributions are made pursuant to a cash or deferred election only if the contributions are made after the employee's performance of service with respect to which the contributions are made (or when the cash or other taxable benefit would be currently available, if earlier)."

With forfeitures, the funds were contributed to the plan long before the service was performed.

It is interesting to note the specific difference between this, and the exception offered for matching contributions - see 1.401(m)-1(a)(2)(iii)(B). I doubt that this is coincidence.

"Tis an interesting question., regardless of which interpretation you choose. Personally, I wouldn't want to have to argue this with the IRS, but I'm generally pretty conservative on most of this stuff. Anyway, I have no pearls of wisdom to offer!

[duckthing]

It sounds like in one post you're wondering if, as long as the $25K withheld ends up in the trust somehow, it's okay. I'd say at best you still have a PT, since in essence you've still lent plan assets to the employer. (And what are you gaining by funding deferrals from forfeitures, then depositing the withheld money to the forfeiture account? If the answer is something like "improve employer cash flow" then you have a problem.)

But in your original post you're asking if the employer can "[1] not transfer to the plan amounts withheld from employees' pay as elective 401(k) contributions and loan repayments and [2] credit to the accounts of the affected employees instead amounts pulled from current forfeitures" (numbering and underline mine). Absolutely not. The withheld amounts are plan assets, and while participant balances might end up the same if this is done, the plan is then short the $25K that was withheld but never deposited.

(Quick example: If allocated assets were $1M, forfeiture account was $100,000, and $25K is withheld from employee checks, then plan assets are $1,125,000 as soon as those withheld amounts can be segregated from the employer's general assets. If the deferrals are "instead" funded from forfeiture account, the trust only contains $1,025,000 in allocated assets and $75K remaining in the forfeiture account. There's $25K missing from plan assets... well, it's not exactly missing -- it's in the employer's checking/general account.)

FWIW, I also think Belgarath's cite is very clear.

[My 2 cents]

One thing to remember - under NO CIRCUMSTANCES can a forfeiture be treated as employer funds.  All forfeitures remain in the trust, to be allocated to something.  The employer cannot use them for any purpose other than to cover amounts like plan expenses or those kinds to participant contributions that the plan and the regulations say can be covered by forfeitures.

Those small plan sponsors who think of the plan assets as their own are always wrong.

[Mike Preston]

What part of "theft" is unclear?

[Luke Bailey]

Mike Preston, it would be correctable. The employer would direct the trustee to remove the allocated forfeitures from the employees' accounts, with earnings, and put them back in the forfeiture suspense account, and then the employer would transfer an equal amount for allocation to the employees' accounts.

As for being "theft," if the employee ends up with the same amount of money in his/her account either way, it's hard for me to see that as theft.

[Mike Preston]

I don't think the DOL would look just at the EE's accounts.  They would look at the plan in total.  Most importantly, they would see the employer's coffers and not like what they see.

[Luke Bailey]

Agree, probably. But PT risk, not theft. We're talking Titles 26 and 29, not 18.

[Mike Preston]

That would be up to the DOL investigator.

[duckthing]

I personally wouldn't want to be the one explaining to a DOL auditor that they were "just borrowing" the forfeiture money.