How to Invest When My 401(k) Fails Nondiscrimination?

Hey everyone, welcome to Episode 105 of Money Girl.

This is Finance Friday, where I answer your burning money questions.

I'm Laura Adams, an award-winning author, spokesperson, money-speaker, and founder of

The Money Stack.

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You can sign up and learn more at LauraDatoms.com.

Today, I have a great question that I don't think I've ever received before.

It comes from Jay P, who says, over the last seven to eight years with two different employers,

they've returned some of my 401k contributions due to failing the discrimination test.

It seems unfair to penalize me for my co-workers' lack of contributions.

What can I do?

Thank you so much for your question, Jay.

I can definitely hear your frustration about not being able to make more contributions

to your retirement plan.

In this podcast, I'll explain what the retirement non-discrimination test is and what to do

if your contributions get returned.

So first, let's talk about what exactly I'm talking about with the non-discrimination

test.

Employers that offer workplace retirement plans get benefits from doing that, like getting

a tax deduction for paying matching contributions.

In addition, employees who participate get valuable benefits, like deferred taxes on contributions

and investment growth.

In exchange, the Internal Revenue Service, or IRS, requires that certain retirement plans

not disproportionately favor highly paid employees or company owners, they require annual

non-discrimination testing to enforce an acceptable balance of participation that

doesn't unfairly benefit top earners or the rest of the workforce.

Employers have to use various non-discrimination tests that compare the average savings or

ownership status of highly compensated employees or HCEs to the average savings of everybody

else.

The calculations get a bit complicated and they do vary depending on the plan, so I'm

going to spare you all the details on the calculations.

However, I will say for 2026, you're considered a highly compensated employee if you earned

over 160,000 or own more than 5% of the company in 2025.

And that amount is likely to go up in future years.

So if the gap between retirement contributions and matching contributions for highly compensated

employees and the rank and file workers is too wide, it means that typical workers

aren't participating enough and the plan will fail the non-discrimination test.

To remain compliant, a company with a failed retirement plan must refund excess contributions

to the high earners to correct the discriminatory participation imbalance.

That's why Jay has had some of his retirement contributions bounce back to his checking

account as regular income from a couple of his employers.

I know Jay's frustration about being a good saver might seem like a champagne problem

to have.

He's doing everything right by making 401k contributions and prioritizing his future.

Yet a portion got returned because his co-workers aren't saving enough.

Now you can't force colleagues to contribute more to a workplace retirement plan.

There are solutions for changing the plan or putting returned contributions to work in

a different account so they keep growing.

So first I want to review a type of plan that allows an employer to avoid these annual

non-discrimination tests that I'm talking about.

And not having these tests can alleviate a significant administrative burden to encourage

more employers to offer retirement benefits.

The IRS created a workplace plan with no testing requirements and it's called a Safe Harbor

401k.

Now the catch with a Safe Harbor 401k is that an employer agrees to make specific mandatory

contributions to its employees' accounts.

For instance, it could match up to 4% of employees' pay with immediate investing.

In return, the IRS waives the employer's non-discrimination test entirely.

So one solution for Jay would be convincing his human resources manager or benefits administrator

to change the company's retirement plan to a Safe Harbor 401k, you know, maybe it would

begin in the following year.

That would be the ultimate fix.

In that case, it could no longer tie Jay's contributions to his co-workers' participation.

He could max out the account by contributing 24,504,206 or even more if he's over age

50, without any fear that a portion could get returned at the conclusion of the tax

year.

Jay could explain to his employer how a Safe Harbor 401k would be a win-win.

His company would offer a more competitive retirement benefit and get to skip the onerous

annual non-discrimination testing.

However, I realize that his employer may not feel so generous about offering a Safe Harbor

401k that requires a matching benefit.

That could be especially true if Jay's employer is a smaller firm that might struggle to offer

a richer benefits package.

Another solution could be for Jay to encourage his employer to automatically enroll new employees

into the retirement plan while allowing them to opt out, you know, if that's not already

the case, auto enrolling workers has shown to increase overall participation rates in

workplace plans.

Or Jay could ask for more education in the workplace about retirement planning and using

a 401k, which could improve enrollment.

That would help workers build stronger financial futures and allow highly paid workers to

contribute more.

However, if Jay works for a small company, there may not be a large number of workers or

new hires who could participate enough to make the discrimination testing work in his favor.

So let's say you're like Jay and have gotten returned retirement contributions.

I want you to remember that they may be taxable.

For instance, any traditional pre-tax contributions will get added to your taxable income for

the year.

So before spending them, consider holding back at least 20-25% for future taxes.

However, if you made any after-tax Roth contributions that get returned to you, they will not affect

your tax liability because they were previously included in your taxable income.

While you might be disappointed to have your retirement contributions denied or returned,

you can still invest them.

An excellent option is to use them to max out a health savings account or HSA if you

have an HSA-qualified health plan.

Since HSA contributions are made on a pre-tax basis, they will help you reduce your tax liability.

For 2026, you can contribute up to $4,400 to an HSA when you have an individual health

plan or $8,750 with a family plan.

In addition, you can contribute an additional $1,000 if you're over $55.

As I mentioned, HSA contributions are tax deductible just like a traditional 401k.

However, you do have to spend them on eligible health care expenses or just keep the account

invested for retirement.

The amazing benefit of an HSA is that you can spend the funds tax-free on qualified

health care costs.

Now another excellent way to invest returned workplace retirement contributions is to

put them in a Roth IRA if you qualify.

For 2026, you can contribute up to $7,500 or $8,600 if you're over $50 to an IRA.

If J is a single taxpayer, the 2026 income limit to max out a Roth IRA is $153,000.

If you're married couples filing jointly, their household income must be under $242,000.

However, you can only contribute after tax funds to a Roth IRA, so they're not going

to help reduce your tax liability.

Let's say J earns too much for a Roth IRA.

In that case, another great way to invest any returned retirement contributions is putting

them in a taxable brokerage account.

Now, it doesn't give you any tax breaks, but it is extremely flexible and can be tapped

penalty-free before or during retirement for any purpose.

J, I want to thank you again for your great question and I hope this gives you some

options for discussing the benefits of a safe harbor 401k with your employer or alternative

ways to invest when you're a highly compensated employee and your 401k fails a nondiscrimination

test.

That's all for now.

I'll talk to you soon.

Until then, here's to living a richer life.

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