Fixing Common Plan Mistakes - Vesting Errors in Defined Contribution Plans


Editor's Note:  This article appeared in the Summer 2005 edition of the Retirement News for Employers. The Pension Protection Act of 2006, signed into law on August 17, 2006, requires that all employer contributions to a defined contribution plan made after December 31, 2006 must vest using either a three year cliff or 6 year graded vesting schedule.

The Issue

Many of you have a 401(k) plan or some other form of qualified defined contribution retirement plan. A qualified defined contribution plan must meet various requirements of the minimum vesting standards found in section 411 of the Internal Revenue Code in order to maintain its status as a qualified plan. The minimum vesting standards are designed to ensure an employee will vest, that is, be entitled to, their accrued benefit within a certain time period. An employer should think of vesting as ownership of the plan benefit by the participant. As is true with the minimum age and service requirements for eligibility purposes, the law provides some options in complying with the minimum vesting requirements. When you established your plan, you made certain plan design choices that relate to these requirements.

An employee’s rights to retirement benefits are determined through the application of a vesting schedule. A vesting schedule defines vesting in terms of percentages which are in turn determined based on the employee’s number of years of service.

Generally, the plan’s vesting must satisfy the legal requirements under one of two minimum schedules: “five-year cliff” vesting or “seven-year graded” vesting. Under five-year cliff vesting, employees must be 100% vested once they’re credited with no more than five years of service. Prior to completing the fifth year of service, the employee’s vesting percentage may be any percentage, including zero. This schedule is known as “cliff” vesting because the employee typically will jump from no vesting to 100% vesting once the employee completes the fifth year of service. Under seven-year graded vesting, employees must be 100% vested once they’re credited with no more than seven years of service. Since 100% vesting can be delayed longer under this option, the law requires that a minimum vesting percentage apply to earlier years. The minimum percentages are as follows:

Upon completion of 3 years of service – 20% vesting;
Upon completion of 4 years of service – 40% vesting;
Upon completion of 5 years of service – 60% vesting; and
Upon completion of 6 years of service – 80% vesting.

Important Note: The forfeiture of the non-vested amount can only occur after the expiration of 5 years of little or no service or, if the plan provides, upon payment of the vested amount if a provision is made for a future buy-back of forfeited amounts. Forfeitures can be allocated to the remaining participants based on a pre-chosen formula or used to reduce future plan contributions.

The Problem

To properly comply with the vesting rules, employers must maintain service records for all employees. Vesting schedules generally refer to “years of service” when assigning a vesting percentage. If these records are incorrect, or if a mistake is made when applying participant data to a vesting schedule, participants will receive incorrect benefit amounts upon leaving the plan. The amounts can be in excess of what is permissible or less than what was due to the participant. The failure to properly follow the vesting rules of the plan can cause the plan to lose its qualified status.

The Fix

Employers may get relief from treatment of their plans as nonqualified through the Employee Plans Compliance Resolution System (EPCRS) by correcting the vesting failures. The Self-Correction Program (SCP) or Voluntary Correction Program (VCP) can be used to correct the mistakes. In order to fix the mistake under SCP, generally the mistake must be fixed within two years after the end of the plan year in which the failure occurred. Unless the failure can be classified as insignificant, VCP must be used after this time.

There is more than one way to correct vesting failures under EPCRS. One way is to use the Contribution Correction Method. A failure in a defined contribution plan to apply the proper vesting percentage to an employee’s account balance that results in forfeiture of too large a portion of the employee’s account balance may be corrected using this method. The employer makes a corrective contribution on behalf of the employee whose account balance was improperly forfeited in an amount equal to the improper forfeiture. The corrective contribution is adjusted for earnings. If, as a result of the improper forfeiture, an amount was improperly allocated to the account balance of another employee, no reduction is made to the account balance of that employee.

Example: Employer E maintains a profit-sharing plan which provides that forfeitures of account balances are reallocated among the account balances of other eligible employees on the basis of compensation. During the 2003 plan year, Employee R terminated employment with Employer E and elected and received a single-sum distribution of the vested portion of his account balance. No other distributions have been made since 2003. However, an incorrect determination of Employee R’s vested percentage was made resulting in Employee R receiving a distribution of less than the amount to which he was entitled under the plan. The remaining portion of Employee R’s account balance was forfeited and reallocated.

Correction: Employer E uses the contribution correction method to correct the improper forfeiture. Thus, Employer E makes a contribution on behalf of Employee R equal to the incorrectly forfeited amount (adjusted for earnings) and Employee R’s account balance is increased accordingly. No reduction is made from the account balances of the employees who received an allocation of the improper forfeiture.

Another way to correct these errors is by use of the Reallocation Correction Method. Generally, the account balance of the employee who incurred the improper forfeiture is increased by an amount equal to the amount of the improper forfeiture and the amount is adjusted for earnings. The account balance of each employee who shared in the allocation of the improper forfeiture is reduced by the amount of the improper forfeiture that was allocated to that employee’s account.

Making Sure It Doesn’t Happen Again

Calculating the vesting percentage of participants receiving benefit payments accurately and timely is vital for employers maintaining defined contribution plans. The plan document, employee data, etc., should be carefully reviewed to ensure that employees are correctly credited with vesting service. When a participant is receiving a benefit pay out, a quick check of the employee’s vesting percentage can prevent these errors before they occur. However, keep in mind that despite all of your good efforts, mistakes can happen. In that case, the IRS can help you correct the problem and retain the benefits of your qualified defined contribution retirement plan.