For many plan sponsors, receiving notice that a 401(k) plan has failed non-discrimination testing can feel alarming. After all, maintaining a compliant retirement plan is a fiduciary responsibility, and few sponsors want to explain why their plan did not meet IRS requirements.
The good news is that a testing failure is not uncommon, particularly among growing organizations, family-owned businesses, professional service firms, and companies with highly engaged leadership teams. More importantly, most failures can be corrected through established IRS procedures.
The key is understanding what happened, why it happened, and what steps can help reduce the likelihood of recurring issues.
The IRS requires qualified retirement plans to provide benefits fairly across employee groups. To help ensure that 401(k) plans do not disproportionately favor owners, executives, or other highly compensated employees (HCEs), many plans must undergo annual non-discrimination testing.
The most common tests include:
When participation and contribution rates among non-highly compensated employees lag significantly behind those of highly compensated employees, the plan may fail one or both tests.
While the terminology can sound technical, the underlying issue is straightforward: the IRS wants retirement plan benefits to be broadly shared throughout the workforce.
A failed test does not mean your plan is being audited, disqualified, or subjected to immediate penalties.
Instead, think of the test result as an indicator that the plan's contribution patterns are out of balance. Most failures are identified during routine annual compliance testing and can be corrected through administrative actions.
The most important response is a timely one. Waiting too long can limit available correction options and increase costs.
Upon receiving the testing results, plan sponsors should review them with their third-party administrator (TPA), retirement plan advisor, and other service providers to understand:
The appropriate correction method depends on the specific test failure and plan design.
One of the most common corrections involves distributing excess deferrals or matching contributions back to highly compensated employees.
While this restores compliance, it is often the least desirable outcome from an executive perspective. Participants receiving corrective distributions may lose some tax-deferred savings opportunities and may express frustration when anticipated retirement contributions are reduced.
Instead of returning contributions to HCEs, employers may choose to make additional contributions to eligible non-highly compensated employees (NHCEs).
This approach can improve testing results while enhancing retirement readiness among employees. Although it involves additional employer expense, many organizations view it as an investment in workforce benefits and employee engagement.
A testing failure often reveals broader workforce participation challenges. Low enrollment, low deferral rates, or limited understanding of retirement benefits may be contributing factors.
Sponsors should use the correction process as an opportunity to examine employee behavior and identify areas for improvement.
Correcting a testing failure addresses the immediate issue. Preventing future failures requires a more strategic approach.
Many organizations discover that recurring testing problems stem from the same underlying factors year after year.
Increasing participation among NHCEs is often the most effective long-term solution.
Consider initiatives such as:
When employees better understand the value of retirement savings and employer matching contributions, participation rates frequently improve.
Automatic enrollment and automatic escalation have become increasingly popular tools for boosting participation and contribution rates.
By automatically enrolling eligible employees and periodically increasing contribution percentages, sponsors can help narrow the gap between HCE and NHCE deferral rates while supporting better retirement outcomes.
For organizations that experience repeated testing failures, a Safe Harbor 401(k) design may be worth exploring.
Safe Harbor plans generally require specific employer contributions and notice requirements but can eliminate the need for certain annual non-discrimination tests. For some employers, the additional contribution cost may be offset by reduced administrative complexity and greater contribution flexibility for owners and executives.
The most effective response to non-discrimination testing failures is often prevention.
Rather than waiting until year-end testing results arrive, sponsors can monitor participation and contribution trends throughout the year. Mid-year reviews can help identify emerging issues early enough to implement corrective measures before testing becomes a concern.
Working closely with a retirement plan professionals can provide valuable insight into workforce demographics, contribution patterns, and plan design alternatives that may improve outcomes for both employees and the organization.
A failed non-discrimination test is not the end of the story — it is an opportunity to take a closer look at how your retirement plan is serving your workforce.
By acting promptly, understanding the underlying causes, and evaluating both short-term corrections and long-term plan design strategies, sponsors can maintain compliance while strengthening the overall effectiveness of their retirement program.
Ultimately, the goal extends beyond simply passing a test. A well-designed 401(k) plan helps employees build retirement confidence, supports talent attraction and retention efforts, and demonstrates an organization's commitment to financial well-being across all levels of the workforce.
To receive valuable insight and plan design alternatives that may improve outcomes for your organization, please contact a member of the Brown & Brown Retirement Plan Services team via our secure form.
Howard Zodicoff serves as a Managing Director in the Retirement and Wealth Solutions division of Brown & Brown team. Howard brings three decades of financial and retirement plan services specialization to his customers and was a business owner prior to joining the firm.
Investment Advisory services provided through Aurora Private Wealth, Inc., a Registered Investment Advisor. Certain representatives of Aurora Private Wealth are also Registered Representatives offering securities through APW Capital, Inc., Member FINRA/SIPC.