When employees leave a company before they’re fully vested in the employer-contributed portion of their 401(k) plan, the non-vested funds don’t just vanish. They become 401(k) forfeitures, or funds held in the 401(k) plan forfeiture account. This account plays a key role in the administration and ongoing management of a company’s retirement plan.
In 2023, the IRS proposed new regulations on how plan sponsors should handle 401(k) forfeitures. For organizations with employer contributions subject to vesting, understanding these rules isn’t optional – it’s a requirement. Improper handling could expose businesses to penalties, qualification failures and fiduciary risks. Consequently, it’s important to use forfeitures within the timeline prescribed in the regulations, which is within 12 months of the close of the plan year in which the forfeitures occurred.1
This guide outlines what are 401(k) forfeitures, how the 401(k) forfeiture account should be used, what the proposed IRS regulations require and how employers can stay compliant.
What are forfeitures?
Employees earn the right to employer-contributed funds in their retirement accounts over a specific timeline that follows either a graded or cliff vesting schedule.2 If an employee terminates employment before they have become fully vested they forfeit a portion of those contributions. A 401(k) forfeiture account is a temporary holding place for those plan assets.
How do forfeitures occur?
Here’s a simple example:
A company offers a 401(k) plan with a five-year graded vesting schedule for employer contributions. An employee departs after two years with 40% vested in employer contributions. They forfeit the remaining 60% of employer-contributed funds, which are then moved into the 401(k) forfeiture account.
Another example:
A company has a 401(k) plan that uses a three-year cliff vesting schedule. An employee leaves after obtaining two years of vesting service. Since they haven’t reached the three-year threshold, they are 0% vested in employer contributions, and the entire employer-contributed amount is forfeited to the plan’s forfeiture account.
Forfeited funds remain part of the plan and must be used for the benefit of plan participants.
Vesting schedule examples
Table 1: Cliff vesting schedule example
With cliff vesting, the employee earns no ownership of the employer contributions until they reach a specific milestone, of no more than three years of service. If they leave before that point, they forfeit 100% of the employer contributions.
| Years of Vesting Service | Vested Percentage of Employer Contributions |
|---|---|
| Less than 3 years | 0% |
| 3 years or more | 100% |
Table 2: Graded vesting schedule example
With graded vesting, employees gradually become vested over a period of time not exceeding 6 years of vesting service. If someone departs after three years, they’re entitled to keep 40% of employer-contributed funds while 60% would be forfeited.
| Years of Vesting Service | Vested Percentage of Employer Contributions |
|---|---|
| 1 Year | 0% |
| 2 Years | 20% |
| 3 Years | 40% |
| 4 Years | 60% |
| 5 Years | 80% |
| 6 Years | 100% |
Proposed IRS 401(k) forfeiture rules took effect in 2024
In February 2023, the IRS and Treasury Department released proposed regulations (REG-122286-18) for how plan sponsors should handle 401(k) forfeitures. They apply to plan years starting on or after January 1, 2024, and although they’re not yet finalized, plan administrators can rely on them now.1
Permitted uses of 401(k) forfeitures
The regulations confirm that forfeiture account balances may be used consistently with the plan terms for:
- Offsetting employer matching or non-elective contributions
- Paying reasonable administrative expenses of the plan
- Providing additional contributions to participants
- Reallocating among participant accounts in accordance with plan provisions
This clarification gives plan sponsors more confidence in how to manage their 401(k) forfeiture account and helps reduce the risk of inconsistent or incorrect allocations.
Deadline for using forfeitures
A significant highlight of the proposed regulation is the timeline for using forfeitures. Most 401(k) plan documents already include a rule requiring that forfeitures be used no later than the end of the plan year following the year in which the forfeiture occurs. The new proposed regulations reinforce this expectation. For example, if a forfeiture occurs in 2024, the plan must use those funds by December 31, 2025. Failure to use forfeitures in a timely manner could lead to operational issues that may jeopardize the plan’s qualified status.
Helpful IRS transition period
The proposed rules also include a transition rule that gives plan sponsors a grace period for clearing out long-standing forfeiture balances.
Under this rule, all forfeitures that occurred before January 1, 2024 are treated as if they occurred during the 2024 plan year, giving employers until the last day of the 2025 plan year (December 31, 2025 for calendar year plans) to use up any accumulated forfeitures without penalty.
This provides a valuable “reset” opportunity for plan sponsors who may have neglected forfeiture account balances in previous years. It’s especially helpful for employers with large, unspent balances from multiple plan years.
Fiduciary considerations for managing forfeitures
Plan sponsors are fiduciaries, meaning they’re legally required to act in the best interest of plan participants. Managing forfeitures is part of this responsibility. As such, plan sponsors must include clear forfeiture guidelines in the plan document and conduct regular plan audits.
Include clear guidelines in the plan document
To reduce the risk of noncompliance, the 401(k) plan document must clearly specify:
- Vesting schedules, e.g., graded vs. cliff
- When forfeitures occur (typically after five consecutive one-year breaks in service or when an employee takes a distribution, if sooner)
- Permitted uses of 401(k) forfeiture funds
- Timeframe for usage
- Process for reallocating forfeited 401(k) funds
Conduct regular plan audits
Routine internal or third-party audits of a 401(k) plan should include a forfeiture account review. Employers must verify that forfeitures are being used appropriately, in accordance with the plan document, and on time. Plan audits help avoid penalties or IRS scrutiny.
When will the new regulations take effect?
While the proposed regulations are not yet final, the IRS stated that plan sponsors could rely on them starting January 1, 2024 for calendar-year plans.
Rather than waiting for the final rule, plan sponsors should take proactive steps now to:
- Review the plan document to make sure it aligns with the proposed rules
- Identify any existing forfeiture account balances
- Create or update internal procedures for allocating forfeitures
- Establish timely use of any past and future forfeitures to avoid noncompliance
The last step especially important if there are unused forfeitures from previous years because the transition rule offers a limited-time opportunity to use those funds without risk of plan disqualification.
ADP Retirement Services helps plan sponsors understand and use forfeiture accounts
Forfeiture process is a critical part of plan administration
Proper forfeiture account management is a key part of plan health and compliance, and it doesn’t have to be burdensome. ADP Retirement Services offers plan sponsors automated tools and support to simplify this process.
Each year, during the fourth quarter, ADP automatically forfeits and reports to plan sponsors any unvested account balances for participants who have experienced five consecutive one-year breaks in service. This aligns with IRS guidelines and helps employers remain compliant without manual tracking.
ADP helps plan sponsors:
- Monitor and report on forfeiture balances
- Apply forfeitures according to plan terms
- Update plan documents when necessary
- Navigate IRS rules and audit preparation
With ADP’s support, plan administrators can manage 401(k) forfeiture accounts more confidently.
Have more questions? Read the ADP forfeiture accounts FAQ
Conclusion
If a 401(k) plan includes employer contributions subject to vesting, understanding how 401(k) forfeitures work is critical.
Here’s what employers can do next:
- Review plan documents for forfeiture provisions
- Assess current forfeiture account balances
- Implement a timely usage process aligned with proposed IRS rules
- Take advantage of the transition rule before the deadline (December 31, 2025 for calendar year plans)
ADP delivers what you need to effectively manage retirement benefits and help employees meet their saving goals.
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1Federal Register, IRS REG-122286-18
Compliance Code:
M-717462-2025-04-09
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