Forfeitures have long been a sleepy corner of 401(k) plan administration, but recent class-action lawsuits are waking everyone up.
Over the past couple of years, plaintiffs’ attorneys have set their sights on how plan sponsors use forfeitures, those leftover funds from employer contributions that aren’t vested when employees leave early. Many plans, following long-standing IRS guidance, use forfeitures to offset future employer contributions. That’s been standard operating procedure. But now, some lawsuits claim that doing so may violate ERISA’s fiduciary standards.
Whether these cases succeed remains to be seen. But if you’re a plan sponsor or fiduciary, now is the time to get your house in order.
The Basics: What Are Forfeitures?
When an employee leaves before employer contributions are fully vested, the non-vested portion is forfeited. ERISA says those forfeitures can’t go back to the employer. The IRS has long said forfeitures may be used to:
· Reduce future employer contributions,
· Pay plan expenses, or
· Provide extra benefits to participants.
In 2023, the IRS proposed rules confirming this—and adding that forfeitures must be used no later than 12 months after the end of the plan year in which they occur.
So far, so good.
The New Legal Theory
Here’s where the litigation flips the script: Plaintiffs argue that using forfeitures to offset employer contributions benefits the company, not plan participants, and therefore violates the fiduciary duty to act “solely in the interest” of participants. They claim that plan sponsors should be using forfeitures to reduce fees borne by participants first, not employer costs.
Some courts have dismissed these claims, others are letting them proceed. And in the post-Loper Bright world, where courts are no longer required to defer to federal agencies’ interpretations of statutes, the long-held IRS guidance may not carry the weight it once did.
What Should You Do?
1. Review Your Plan Document. Make sure the way your plan uses forfeitures is spelled out clearly—and that you’re following it. If your plan document gives discretion to fiduciaries, that can be a litigation risk.
2. Consider Removing Discretion. The more discretion fiduciaries have, the more second-guessing plaintiffs can do. You may want to amend your plan to say forfeitures shall be used in a specific way—like paying expenses first, then reducing employer contributions.
3. Document Your Process. If you’re applying forfeitures correctly and in line with the plan document, write it down. Keep a record. If you ever face scrutiny, documentation will be your best defense.
The Bottom Line
This may seem like an attack on long-standing practice—but it’s more about litigation strategy than legal clarity. Still, plan sponsors can’t ignore it. As always, the safest path is to follow the plan, eliminate ambiguity, and document everything.
It’s one more reminder that in ERISA, even the smallest buckets of money come with big responsibilities.
