Definitions Deep Dive

Understanding the various features and their impact in a retirement plan is important to understand which would best meet your objectives. JM Pension dives into these features by providing definitions as a framework for designing your Plan. Scroll through this page for all definitions or select from the list below to jump straight to that definition.

Partial Plan Termination

 A Plan Sponsor may terminate its plan for various reasons. To terminate a plan, several steps must be followed. However, it is possible for a partial termination to occur indirectly (meaning it was not the intent of the Plan Sponsor to do so). A partial plan termination occurs when a significant number or percentage of employees who participate in the plan are terminated and/or are no longer eligible to participate in the plan.  

While IRS looks at all facts and circumstances to determine what is “significant”, a strong rule of thumb is when an employer reduces its workforce (and plan participants) by 20% or greater.  (Note that IRS provided greater latitude for COVID years 2020 and 2021).  The turnover rate is calculated by dividing employees terminated from employment (or excluded from the plan via a plan amendment) by all participating employees during the applicable period, which is generally the plan year.  IRS can look at a longer period; for example, if there are a series of related severances of employment that stretch beyond the plan year.  Note that the terminated participants are those who have involuntarily terminated, not those who have left voluntarily or have left and were not within the employer control (such as death, disability or retirement).  As mentioned previously, IRS will look at all facts and circumstances regarding which employees are affected.  It is possible IRS would opine that if an employee voluntarily terminates due to pending employer intent to fire, foreseeable impact of the employer’s conduct, or working conditions, it is the same as if the employer took action for purposes of calculating whether a partial termination occurred.

If your turnover rate is over 20% and it is considered routine for your company, it may be possible to avoid classification as a partial termination.  Factors relevant include: (1) were terminated employees replaced; (2) if yes, did the new employees perform the same functions; (3) did the new employees hold the same job classification or title, and (4) did the new employees receive comparable compensation.

If it is determined that your plan experienced a partial termination, the affected participants must become 100% vested in all employer contributions in their account regardless of the vesting schedule associated with those contributions or the length of service worked by the participants.  Failure to do so will jeopardize the tax-qualified status of the plan.

Vesting

First of all, vesting means ownership.  Each employee will vest (own) all or a portion of his/her account in the Plan based on the plan’s vesting schedule.  A Plan may have multiple sources of funds:  the employee deferral, the employee rollover into the plan, employer monies and employer safe harbor monies.  Certain sources require that the employee be immediately vested and other sources may be tied to a vesting schedule.

There are three types of vesting schedules:  immediate, cliff and graded.  Immediate means that all monies are owned by the employee 100% upon receipt.  Cliff vesting means that the employee must work a certain period of time before the employee he/she is 100% vested, while graded vesting means that an employee will vest (own) a portion of the monies each year worked until it reaches 100%.  For cliff vesting, the maximum length of time is three years if your Plan is top heavy.  For graded, it is six.  Note that for graded, the first year is zero% and increases 20% per year thereafter.  You can modify these schedules to lessen the time of vesting. 

What sources are not tied to a vesting schedule (100% own immediately)?  All employee contributions such as 401k and monies rolled into the Plan by the employee are 100% vested. Additionally, if the company’s 401k plan is a safe harbor plan (the company makes safe harbor contributions in the form of a percentage of pay or a match as defined in the Plan to satisfy testing), those safe harbor contributions are also 100% vested.  Sources tied to a vesting schedule are non-safe harbor employer contributions (generally match and profit sharing).

There are two instances that IRS requires an employee be 100% vested in all sources of funds regardless of the vesting schedule:  (1) once the employee reaches normal retirement age as defined by the Plan (generally age 65), or (2) the Plan is terminated.  Other instances that require an employee be 100% vested in all sources of funds will be outlined in your Plan document.  The most common are upon disability or death.

There are two methods of counting service for vesting:  one is the hours of service method and the other is the elapsed time method.  For the hours of service method, the employee is required to work 1000 hours in one year to earn a year of service for vesting purposes.  The 1000 hours is customary; however you may reduce the hours required if desired.  Under the elapsed method, a year of vesting is based on the years from the employee’s date of hire.  If an employee is still active twelve months from their date of hire (or date of anniversary after the first year of employment), regardless of hours worked, he/she will be credited with a year of service. 

When establishing a new plan, the plan may be designed to ignore all years of service prior to the inception of the plan.  Let’s look at an example:  Assume DO Music, Inc. sponsors a 401k plan.  Now it wants to sponsor a Cash Balance Plan effective January 1, 2023 with a three year cliff vesting schedule using hours method (1000) to count service.  Lil has worked for DO Music since 2010.  If all years of service are counted, she is 100% vested in the new plan.  However, if the plan is designed to ignore service before the plan’s inception date of January 1, 2023, Lil will not be 100% vested unless she has worked at least 1000 hours in plan years 2023, 2024 and 2025.

Forfeitures

Most defined contribution plans require participants to complete a certain number of years of service before becoming fully vested (own 100%) in contributions such as a company match or profit sharing.  If a participant terminates employment before becoming fully vested, the non-vested monies in the account are “forfeited”.  These monies are moved from the participant’s account to a holding account within the Plan generally referred to as a Forfeiture account.  

Funds are forfeited the earlier of: a) the terminated participant requests a distribution of his/her account balance or (b) the terminated participant has incurred five consecutive one-year breaks-in-service.  (A break-in-service occurs on the last day of a plan year in which the former employee works fewer than 501 hours). 

Regulations allow plans to utilize three possible options for using forfeitures. Your plan document specifies how forfeitures are to be used in your plan. Penalties and possible plan disqualification can occur if forfeitures are not used in one of the following ways: 

  1.  The Plan can supplement the company contribution to plan participants, adding the amount in its forfeiture account to the amount it will contribute to participants. 

  2. The Plan Sponsor can offset its contribution to plan participants. The forfeiture account becomes a “credit”.  

    • Example: the company’s matching contribution will equal $50,000 for the 2023 plan year. The forfeiture account balance value is $3,000.  The company will deposit $47,000 to the plan, using $3,000 towards its $50,000 obligation. 

  3.  The Plan Sponsor can offset administrative, accounting, audit or legal expenses it incurs for the plan. 

    • Example: JM Pension invoices the Plan Sponsor, who in turn, authorizes the Custodian to pay the fee from the forfeiture account. 

Note that it is NOT an option to distribute the forfeited funds back to the company.  To do so would be in violation of IRS regulations. Why? The company already took a tax deduction to contribute the monies in earlier years so it must remain in the plan.   

Non-vested monies cannot remain in the Forfeiture account indefinitely.  IRS has emphasized the timeliness of using forfeitures. Generally, the forfeitures must be utilized no later than the end of the following plan year. This is common if forfeitures are used to offset plan expenses.  If you are utilizing option one or two above, it is more common to utilize the forfeitures when funding the employer contribution for that year.   JM Pension reviews your forfeiture account balance at least annually and advises you on your possible uses when we conclude the annual administrative reports for your plan.