If you sponsor a 401(k) plan, forfeitures are one of those topics that can quietly create significant legal exposure if they are not handled correctly. They arise routinely — whenever an employee leaves before becoming fully vested — but the rules around what you can do with them, and when, are more prescribed than many plan sponsors realise.

This guide covers what forfeitures are, how they are allocated, the accounting treatment, recent DOL enforcement activity, the wave of class-action litigation that has reshaped how plan sponsors must think about this issue, and what to do if your plan has a forfeiture problem.

For a broader overview of your obligations as a plan sponsor, see our ERISA compliance guide for plan sponsors.

What is a 401(k) forfeiture?

A forfeiture occurs when a plan participant leaves employment before they are fully vested in the employer contributions made on their behalf. The unvested portion of their account does not follow them — it stays in the plan and becomes a forfeiture.

Vesting schedules determine how quickly an employee earns the right to employer contributions. A three-year cliff schedule, for example, means an employee who leaves after two years forfeits 100% of employer contributions. A six-year graded schedule might mean they leave with 40% vested and forfeit the remaining 60%. The specific schedule is defined in the plan document.

Forfeitures accumulate in a forfeiture account within the plan. What happens to that account — and when — is where the legal complexity begins.

What can forfeitures be used for?

Under ERISA rules, plan forfeitures may be used for one or more of three purposes, depending on what the plan document permits:

To reduce future employer contributions. The most common use. Instead of making the full employer contribution in a given year, the employer draws down the forfeiture account to offset some or all of that obligation.

To pay plan administrative expenses. Forfeitures can be used to cover reasonable plan expenses — recordkeeping fees, audit costs, and similar charges — rather than billing those costs to participant accounts.

To make additional allocations to participants. Forfeitures can be reallocated to remaining participants’ accounts, effectively increasing their balances.

The critical point is that the plan document must specify which of these uses is permitted and in what order of priority. Using forfeitures in a way that is not authorised by the plan document is a compliance failure, regardless of whether the IRS would otherwise permit it.

When must forfeitures be used?

The IRS issued final regulations in 2024 requiring that forfeitures be used no later than the end of the plan year following the plan year in which they arose. This closed a long-standing ambiguity that had allowed some plan sponsors to let forfeiture accounts accumulate for years without allocation.

The timing requirement means plan sponsors must now actively monitor forfeiture balances and ensure they are deployed within the required window. Letting a forfeiture account sit unused beyond the deadline is a plan document failure and a compliance issue that will draw scrutiny on audit.

The fiduciary dimension

Forfeitures are not just a tax and administrative issue — they carry fiduciary implications. Under ERISA, plan fiduciaries must act solely in the interests of plan participants. The decision about how to use forfeitures — particularly the choice between reducing employer contributions and allocating to participants — must be made consistent with that standard and with the plan document.

This is where recent litigation has focused. The argument in several high-profile cases is that using forfeitures to reduce employer contributions benefits the employer, not participants, and that where the plan document permits either use, fiduciaries who consistently choose the employer-favourable option may be in breach of their duty of loyalty.

Understanding your fiduciary obligations in full is essential before making forfeiture decisions. Our guide to 401(k) fiduciary duties covers the four core duties, the prudent investor standard, and personal liability in detail. For a broader overview of fiduciary services under ERISA, see our post on fiduciary services under ERISA.

Recent litigation: the Nordstrom and HP cases

The surge in 401(k) forfeiture litigation over the past two years has put this issue firmly on the compliance radar for plan sponsors of all sizes. The two cases that have most clearly defined the legal landscape are Nordstrom and HP.

In the Nordstrom case, plaintiffs alleged that the company failed to act prudently and loyally in its management of plan forfeitures. Specifically, the complaint alleged that Nordstrom used forfeiture balances to reduce its own employer contribution obligations rather than allocating those amounts to participant accounts. The plaintiffs argued this constituted self-dealing — using plan assets for the benefit of the employer rather than participants — in violation of ERISA’s prohibited transaction rules under Section 406.

The HP case raised similar allegations. HP faced claims that its practice of using forfeitures to offset employer contributions, rather than to pay plan expenses or increase participant allocations, was inconsistent with the plan document and with fiduciary duties. The case drew particular attention because of the scale of the forfeiture balances involved and the length of time over which the practice had continued.

Both cases have proceeded through the courts and have contributed to a wave of copycat litigation from Class Action Law Firms targeting plan sponsors across a range of industries. The key takeaway is not that using forfeitures to reduce employer contributions is automatically unlawful — in many cases it is expressly permitted by the plan document. The risk arises when the plan document is ambiguous, when the chosen use is not the one permitted, or when the decision-making process is not documented.

For context on the broader landscape of ERISA prohibited transactions and the rules around self-dealing, see our post on prohibited transactions and exemptions.

DOL enforcement: what auditors are looking for

The Department of Labor’s Employee Benefits Security Administration (EBSA) has identified forfeiture handling as an area of active audit focus. When EBSA auditors review a 401(k) plan, forfeiture accounts are among the items they examine. The specific issues they look for include the following.

Whether forfeitures were allocated within the required timeframe. Balances that have been sitting in a forfeiture account beyond the plan-year-plus-one deadline are an immediate red flag.

Whether the use of forfeitures is consistent with the plan document. Auditors will compare the actual use of forfeitures against the plan document’s stated provisions. Any mismatch is a compliance failure.

Whether the allocation methodology was applied correctly. If forfeitures are reallocated to participants, auditors will check that the allocation formula in the plan document was followed accurately.

Whether the decision to use forfeitures in a particular way was documented. Given the litigation environment, auditors are increasingly looking for evidence that fiduciaries made a deliberate, documented decision — not just that the outcome was permissible.

Plan sponsors who have experienced an EBSA audit know that preparation is everything. Our guide to surviving an EBSA audit covers what to expect and how to prepare.

Accounting treatment for 401(k) forfeitures

From an accounting perspective, forfeitures must be tracked separately from other plan assets. The forfeiture account sits within the plan’s trust and must be reported accurately on the Form 5500 annual return.

When forfeitures are used to reduce employer contributions, the accounting entry offsets the contribution payable against the forfeiture balance. When they are used to pay plan expenses, the expense is charged against the forfeiture account rather than participant accounts. When they are reallocated to participants, the allocation increases individual account balances.

In each case, the plan’s third-party administrator (TPA) should be tracking forfeiture activity and ensuring it is reported correctly. If your TPA is not providing a clear accounting of forfeiture balances and their use each plan year, that is worth addressing directly. Errors in forfeiture accounting are one of the more common findings in plan audits, particularly for larger plans that are required to file audited financial statements alongside the Form 5500.

What if your plan has a forfeiture problem?

If you have identified an error in how forfeitures have been handled — forfeitures used in a way not permitted by the plan document, timing violations, or incorrect allocations — there are correction options available. The IRS Employee Plans Compliance Resolution System (EPCRS) provides a structured framework for self-correcting plan errors, including those involving forfeitures.

For more significant errors, or those that come to light during an audit, the Voluntary Fiduciary Correction Program (VFCP) administered by the DOL allows plan sponsors to voluntarily disclose and correct certain fiduciary violations. Using the VFCP proactively — before an audit — typically results in significantly better outcomes than being found in violation during an examination.

For a detailed explanation of the VFCP and how correction programmes work in practice, see our post on voluntary fiduciary correction.

Is your 401(k) plan in good shape? Take our health check

Forfeiture handling is one of several areas where 401(k) plans commonly fall out of compliance without plan sponsors realising it. Others include late contribution deposits, improper plan loans, missing participant notices, and outdated investment lineups.

Our 401(k) plan health check is a structured self-assessment designed to help plan sponsors identify gaps across the key areas of plan compliance — including forfeitures, fiduciary governance, plan document provisions, and investment oversight. It takes around ten minutes to complete and gives you a clear picture of where your plan stands.

If the health check surfaces any areas of concern, our team is available to talk through what they mean and what corrective steps are appropriate. Book a consultation to discuss your results.

Plan document review: the starting point

Given the litigation and enforcement environment, the most important immediate action for any plan sponsor is a thorough review of the forfeiture provisions in the plan document. Specifically, you need to understand the following.

Which uses of forfeitures are permitted — contribution offset, expense payment, reallocation, or some combination.

Whether there is a stated order of priority if multiple uses are permitted.

What the timing requirements are and whether current practice meets them.

Whether the allocation methodology for any reallocation is clearly defined and being followed.

If the plan document is ambiguous on any of these points, an amendment may be appropriate. Ambiguity is itself a risk — it is what allowed the Nordstrom and HP lawsuits to proceed in the first place.

Our 401(k) plan design and efficiency review service includes a review of plan document provisions including forfeiture handling, and can identify gaps before they become compliance issues.

What plan sponsors should do now

The forfeiture issue has moved from a background administrative matter to a front-line fiduciary concern. The combination of the 2024 IRS final regulations, the active DOL enforcement environment, and the growing volume of participant litigation means this is not an area where a passive approach is adequate.

The practical steps are straightforward. Review the plan document to confirm what it says about forfeitures. Check the current forfeiture account balance and confirm that any amounts arising in the prior plan year have been allocated within the required timeframe. Confirm that the use of forfeitures is consistent with the plan document. Document the decision-making process. And if there are errors, use the available correction mechanisms proactively rather than waiting for an audit.

If your organisation sponsors a 401(k) plan and would like a review of your forfeiture processes and plan document, book a consultation with our team.

ERISA Advisory Group provides independent fiduciary and consulting services for ERISA plans. For more on our qualified retirement plan consulting services, visit our qualified retirement plans page.