1005. Is your company "returning" your retirement savings? In this episode, Laura answers a listener question from Jay P., who is frustrated that his contributions keep getting bounced back as taxable income.
1005. Is your company "returning" your retirement savings? In this episode, Laura answers a listener question from Jay P., who is frustrated that his contributions keep getting bounced back as taxable income.
If you’re a high earner or a diligent saver, nothing is more frustrating than seeing your hard-earned 401(k) contributions returned to your checking account. But why does the IRS penalize you just because your coworkers aren’t saving enough?
In this episode, Laura breaks down the "Highly Compensated Employee" (HCE) rules and explains exactly why your retirement plan might be failing its annual nondiscrimination tests. More importantly, she shares the specific steps you can take to keep your momentum going even when your workplace plan hits a ceiling.
Laura goes over:
Find a transcript here.
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Hey everyone! Welcome to episode 1,005 of Money Girl! This is Finance Friday, where I answer your burning money questions. I'm Laura Adams, an award-winning author, on-camera spokesperson, female money speaker, and founder of The Money Stack, that's my Substack newsletter. You can sign up for and learn more at LauraDAdams.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 401(k) contributions due to failing the discrimination test. It seems unfair to penalize me for my coworkers' 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 nondiscrimination test is and what to do if your contributions get returned.
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 (IRS) requires that certain retirement plans not disproportionately favor highly paid employees or company owners. They require annual nondiscrimination testing to enforce an acceptable balance of participation that doesn’t unfairly benefit top earners over the rest of the workforce.
Employers have to use Various nondiscrimination tests that compare the average savings or ownership status of highly compensated employees (HCEs) to the average savings of everyone else. The calculations get a bit complicated and vary depending on the plan, so I’ll spare you the details on the calculations.
However, for 2026, you’re considered an HCE if you earn 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 HCEs and “rank-and-file” workers is too wide, it means that typical workers aren’t participating enough, and the plan will fail the nondiscrimination 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 401(k) contributions and prioritizing his future, yet a portion got returned because his coworkers aren’t saving enough.
While 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.
First, let’s review a type of plan that allows an employer to avoid these manual nondiscrimination tests. 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, called a Safe Harbor 401(k).
The catch with a Safe Harbor 401(k) 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 vesting. In return, the IRS waives the employer’s nondiscrimination 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 401(k). 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 coworkers’ participation. He could max out the account by contributing $24,500 for 2026 (or even more if he’s over 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 401(k) would be a win-win. His company would offer a more competitive retirement benefit and get to skip the onerous annual nondiscrimination testing.
However, I realize that his employer may not feel so generous about offering a Safe Harbor 401(k) 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, 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 401(k), 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.
RELATED: How to maximize retirement matching funds
How to invest returned retirement contributions?
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% to 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 (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 401(k). However, you do have to spend them on eligible healthcare expenses or keep the account invested for retirement. The amazing benefit of an HSA is that you can spend the funds tax-free on qualified healthcare 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 Jay is a single taxpayer, the 2026 income limit to max out a Roth IRA is $153,000. For 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 Jay 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.
Jay, 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 401(k) with your employer or alternative ways to invest when you’re an HCE and your 401(k) 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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