Highly compensated employee

• LINK_POOL Table:

• External Links:

  1. IRS Retirement Plans Definitions: https://www.irs.gov/retirement-plans/retirement-plans-definitions
  2. Employee Retirement Income Security Act (ERISA) - U.S. Department of Labor: https://www.dol.gov/general/topic/retirement/erisa
  3. SHRM: Prepare for FLSA's New Salary Thresholds for Highly Compensated Employees: https://www.shrm.org/resources-and-tools/hr-topics/compensation/pages/flsa-new-salary-thresholds-highly-compensated-employees.aspx
  4. IRS: 401(k) Plan Fix-It Guide — The plan failed the 401(k) ADP and ACP nondiscrimination tests: https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-the-plan-failed-the-401k-adp-and-acp-nondiscrimination-tests

What Is a Highly Compensated Employee?

A Highly Compensated Employee (HCE) is a classification used by the U.S. Internal Revenue Service (IRS) to ensure that employer-sponsored retirement plans, particularly 401(k) plans, do not disproportionately favor high-earning individuals. This classification falls under the broader financial category of Retirement Planning. The IRS sets specific criteria to identify a Highly Compensated Employee, which impacts the administration and compliance of a qualified plan. The rules governing Highly Compensated Employees are designed to promote fairness in retirement savings accounts across all levels of an organization.

History and Origin

The concept of a Highly Compensated Employee and the associated regulations originated from the Employee Retirement Income Security Act of 1974 (ERISA). ERISA is a federal law that established minimum standards for most voluntarily established retirement and health plans in private industry, aiming to protect the interests of plan participants and their beneficiaries., ³³Before ERISA, some retirement plans could be structured to primarily benefit business owners and top executives, potentially leaving other employees with inadequate benefits. To address this, ERISA introduced provisions to ensure that such plans were operated in a non-discriminatory manner. The IRS, which shares oversight of ERISA with the Department of Labor, subsequently developed specific definitions and non-discrimination testing requirements for retirement plans, including the identification of Highly Compensated Employees. T³²hese rules aim to ensure that the tax benefits associated with these plans are broadly shared among all employees, not just a select few.

Key Takeaways

• A Highly Compensated Employee (HCE) is defined by the IRS based on ownership or compensation thresholds.
• The HCE classification primarily impacts 401(k) plan contributions and other employer-sponsored benefit plans.
• Companies must conduct annual non-discrimination testing to ensure that their plans do not disproportionately favor Highly Compensated Employees.
• If a plan fails non-discrimination testing, corrective actions may be required, which could involve limiting HCE contributions or making additional employer contributions to other employees.
• The compensation threshold for HCE status is adjusted annually for inflation by the IRS.

Formula and Calculation

An employee is generally considered a Highly Compensated Employee (HCE) if they meet either of the following two criteria for the look-back year (the year preceding the plan year):

1. Ownership Test: The employee owned more than 5% of the interest in the business at any time during the current or preceding year, regardless of their compensation.,
   2³¹. Compensation Test: The employee received compensation from the business exceeding a specific dollar limit set by the IRS. For the 2025 plan year, this limit is \($160,000\) (based on compensation in the 2024 tax year).,

³⁰Additionally, employers have the option to include a "top 20% rule" for the compensation test. If this election is made, an employee must not only exceed the compensation threshold but also be in the top 20% of employees when ranked by compensation for the preceding year to be considered an HCE.,
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28The compensation used for HCE determination generally includes wages, salaries, bonuses, commissions, and elective deferrals to 401(k) plans and cafeteria plans.

Interpreting the Highly Compensated Employee

The designation of a Highly Compensated Employee (HCE) is crucial for employers administering defined contribution plans like 401(k)s. This classification is not merely an arbitrary label but a regulatory tool designed to ensure equity in employee benefit programs. If a significant disparity exists between the participation or contribution rates of HCEs and Non-Highly Compensated Employees (NHCEs), the plan may be deemed discriminatory. F²⁷or instance, if HCEs contribute a substantially higher percentage of their compensation to their 401(k)s compared to NHCEs, it could lead to the plan failing its annual non-discrimination testing. This interpretation emphasizes that the intent of the rules is to encourage broad-based participation and equitable access to tax-advantaged retirement savings. The goal is to prevent situations where the tax benefits of a qualified retirement plan disproportionately benefit a small group of highly paid individuals.

Hypothetical Example

Consider "TechInnovate Inc.," a software development company. For the 2025 plan year, the IRS compensation threshold for a Highly Compensated Employee (HCE) is \($160,000\) based on 2024 earnings. TechInnovate Inc. has decided to use the "top 20% rule."

Here's a breakdown of some employees and their HCE status for 2025:

• Alice, CEO: Owns 10% of TechInnovate Inc. and earned \($300,000\) in 2024.
  • Status: Alice is an HCE because she owned more than 5% of the company, regardless of her compensation.
• Bob, Senior Developer: Earned \($180,000\) in 2024. When ranked by compensation, Bob is in the top 15% of all employees.
  • Status: Bob is an HCE because his 2024 compensation exceeded \($160,000\) and he was in the top 20% of earners.
• Carol, Project Manager: Earned \($170,000\) in 2024. However, with the "top 20% rule," Carol falls outside the top 20% of earners at TechInnovate Inc.
  • Status: Carol is not an HCE. While her compensation exceeded the threshold, she was not in the top 20% of earners at the company.
• David, Software Engineer: Earned \($120,000\) in 2024 and owns no part of the company.
  • Status: David is not an HCE, as his compensation is below the threshold and he has no ownership interest.

This example illustrates how both ownership and the compensation test (potentially with the top 20% election) determine HCE status, affecting how their employee contributions to the 401(k) are treated for compliance purposes.

Practical Applications

The classification of a Highly Compensated Employee (HCE) has significant practical applications, primarily in the realm of employer-sponsored retirement plans. The most critical application is in relation to non-discrimination testing for 401(k) plans. The IRS mandates these annual tests, such as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to ensure that the benefits provided by a 401(k) plan do not unfairly favor HCEs over Non-Highly Compensated Employees (NHCEs).,
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25If a plan fails these tests, it can have direct consequences for HCEs. For example, excess contributions made by HCEs might need to be refunded to them, which then becomes taxable income in the year of distribution. Alternatively, the employer might need to make additional employer contributions to NHCEs to bring the plan into compliance. T²⁴his incentivizes employers to encourage broader participation and higher contribution rates among their entire workforce.

Beyond 401(k)s, the HCE definition can also apply to other employee benefit plans, such as certain health and welfare plans, subject to their own non-discrimination rules. E²³mployers must accurately identify HCEs to remain compliant with federal regulations and avoid penalties from the IRS. The U.S. Department of Labor (DOL) also oversees aspects of the Employee Retirement Income Security Act (ERISA), which underpins these regulations, ensuring fair administration of employee benefits.

²²## Limitations and Criticisms

While the concept of the Highly Compensated Employee (HCE) and associated non-discrimination testing aims to ensure fairness in retirement plans, there are limitations and criticisms. One common critique is that these rules can inadvertently limit the ability of HCEs to maximize their retirement savings accounts. If a company's Non-Highly Compensated Employees (NHCEs) do not participate sufficiently in the 401(k) plan, the contributions of HCEs may be restricted, even if those HCEs are diligently saving for their own retirement. T²¹his can lead to frustration for individuals who are classified as HCEs, especially those who may not feel "highly compensated" in high-cost-of-living areas or who have significant financial responsibilities.

²⁰Furthermore, the complexity of the non-discrimination tests and the penalties for failure can be burdensome for employers, particularly small and medium-sized businesses. T¹⁹he administrative burden and the potential for corrective distributions can make offering a 401(k) plan more challenging. While safe harbor 401(k) plans offer an exemption from certain tests, they require mandatory employer contributions, which might not be feasible for all businesses. T¹⁸he rules are intended to prevent a plan from benefiting only top earners and those with ownership interests, but the practical application can sometimes lead to unintended consequences for both employers and highly compensated employees.

¹⁷## Highly Compensated Employee vs. Key Employee

While both Highly Compensated Employee (HCE) and Key Employee classifications are used by the IRS for retirement plan compliance, they serve distinct purposes and have different criteria.

While there can be overlap (an employee might be both an HCE and a Key Employee), the definitions and the tests they influence are separate. Understanding these distinctions is critical for proper 401(k) plan administration and compliance.

FAQs

What does HCE mean in 401(k)?

In the context of a 401(k) plan, HCE stands for Highly Compensated Employee. This is an IRS classification that impacts how much an individual can contribute to their 401(k) if the plan does not pass specific non-discrimination testing designed to ensure fair benefits for all employees.

How is Highly Compensated Employee (HCE) determined?

An employee is generally determined to be an HCE if they meet either an ownership test (owning more than 5% of the business) or a compensation test (earning above an annually adjusted dollar limit in the preceding year, potentially coupled with being in the top 20% of earners).,

⁴### Why are Highly Compensated Employees (HCEs) limited in their 401(k) contributions?

The IRS limits HCE contributions to ensure that the tax benefits of 401(k) plans are not disproportionately enjoyed by high-income earners. This promotes equitable access to retirement savings accounts across all employee groups within a company.

What happens if a company fails HCE non-discrimination tests?

If a company's 401(k) plan fails non-discrimination tests, corrective actions are required. These can include refunding excess contributions to HCEs (which then become taxable income for them) or making additional employer contributions to Non-Highly Compensated Employees to bring the averages into compliance.,
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2### Can a Highly Compensated Employee (HCE) still maximize their retirement savings?

While direct 401(k) contributions may be limited if a plan fails non-discrimination tests, HCEs can explore other avenues for retirement savings, such as Individual Retirement Accounts (IRAs), including "backdoor Roth IRA" strategies if eligible, or non-qualified deferred compensation plans.¹