Highly compensated employee hce

What Is a Highly Compensated Employee (HCE)?

A highly compensated employee (HCE) is a classification used by the Internal Revenue Service (IRS) to identify individuals in a company whose compensation or ownership interest meets specific thresholds. This designation, falling under the broader category of employee benefits and tax law, is crucial for employers when conducting annual non-discrimination testing for qualified retirement plans, such as a 401(k) plan. The primary purpose of identifying HCEs is to ensure that tax-advantaged retirement plans do not disproportionately favor higher-earning or ownership-holding employees over other members of the workforce.

History and Origin

The concept of a highly compensated employee (HCE) is rooted in federal legislation designed to ensure fairness in employer-sponsored benefit plans. The Employee Retirement Income Security Act of 1974 (ERISA) established foundational standards for private industry retirement plans. However, it was later tax reform, particularly the Tax Reform Act of 1986, that introduced specific definitions and regulations for HCEs as part of broader anti-discrimination rules for qualified plans. The IRS periodically updates the compensation thresholds that define an HCE, reflecting changes in the economic landscape and ensuring the ongoing relevance of the rules. The IRS specifically mandates non-discrimination testing to prevent plans from disproportionately benefiting highly compensated individuals, ensuring that the associated tax benefits.

Key Takeaways

• A highly compensated employee (HCE) is an IRS classification for individuals based on their compensation or ownership in a business.
• The HCE designation is critical for employers to perform annual non-discrimination testing on qualified retirement plans.
• These tests ensure that tax-advantaged plans do not unfairly favor HCEs over non-highly compensated employees (NHCEs).
• HCE status can lead to limitations on an individual's personal contributions to certain defined contribution plans like 401(k)s.
• The IRS updates the compensation threshold for HCE status annually.

Interpreting the Highly Compensated Employee (HCE)

The determination of who qualifies as a highly compensated employee (HCE) is essential for employers managing qualified benefit plans. Generally, an employee is considered an HCE for a plan year if they meet one of two criteria during the preceding year:

1. Ownership Test: The employee owned more than 5% of the ownership interest in the business at any time during the current or preceding plan year, regardless of their compensation. This includes direct ownership as well as ownership attributed through immediate family members like spouses, children, and grandchildren¹⁶.
2. Compensation Test: The employee received compensation exceeding a specific dollar amount set by the IRS for the preceding year. For example, in 2025, the compensation threshold for HCE determination in 2026 is $160,000¹⁵. Employers may also choose to apply a "top 20% rule," meaning only those employees who meet the compensation threshold and are in the top 20% of employees ranked by compensation are considered HCEs¹³, ¹⁴.

This classification directly impacts how employers structure and evaluate their employee benefit programs, particularly those offering significant tax benefits.

Hypothetical Example

Consider "Tech Solutions Inc.," a company with 100 employees. For the 2026 plan year, the IRS highly compensated employee (HCE) threshold is $160,000 for compensation earned in 2025.

• Employee A: Earned $180,000 in 2025 and owns 1% of Tech Solutions Inc. Since their compensation exceeds $160,000, Employee A is classified as an HCE.
• Employee B: Earned $90,000 in 2025 but owns 6% of Tech Solutions Inc. Due to the ownership interest exceeding 5%, Employee B is also an HCE, regardless of their lower salary.
• Employee C: Earned $170,000 in 2025 but Tech Solutions Inc. elects the "top 20% rule" for its HCE determination. If Employee C is not among the top 20 highest-paid employees in the company, they might not be classified as an HCE, assuming no ownership stake.
• Employee D: Earned $75,000 in 2025 and owns no part of the company. Employee D is considered a non-highly compensated employee (NHCE).

The company's plan administrator will use these classifications when performing annual non-discrimination testing for their 401(k) plan.

Practical Applications

The highly compensated employee (HCE) designation primarily affects the administration and compliance of employer-sponsored tax-advantaged plans, particularly qualified retirement plans like 401(k)s.

1. Non-Discrimination Testing (NDT): The most significant application is in annual non-discrimination testing, mandated by the IRS. These tests, such as the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test, compare the average contribution rates of HCEs to those of non-highly compensated employees (NHCEs)¹¹, ¹². If HCEs contribute significantly more, the plan may fail the tests, necessitating corrective actions.
2. Contribution Limitations: If a plan fails NDT, HCEs may be required to receive a refund of their excess elective deferrals or employer matching contributions to bring the plan into compliance⁹, ¹⁰. This limits the amount of pre-tax compensation that HCEs can contribute to their 401(k)s, which in turn reduces their immediate taxable income.
3. Plan Design and Compliance: Employers, especially smaller businesses, often design their 401(k) plan to pass NDT. This can involve implementing "safe harbor" provisions or encouraging greater participation from NHCEs to allow HCEs to maximize their contributions. Employers must also be mindful of fiduciary responsibilities to ensure the plan operates fairly for all participants.

Limitations and Criticisms

While the highly compensated employee (HCE) rules aim to promote equity in employee benefits, they come with certain limitations and criticisms. One common critique is that these regulations can inadvertently restrict the ability of higher-earning individuals to save for retirement through their employer's qualified plan, even when they wish to maximize their contributions⁷, ⁸. This can be particularly frustrating for employers whose highly compensated employees are willing to save more, but are capped due to low participation rates among non-highly compensated employees⁶.

Furthermore, the complexity of non-discrimination testing can be a burden for businesses, requiring careful monitoring and potentially costly corrective actions if tests are failed. Some argue that these rules disproportionately affect small businesses, which may have a smaller pool of employees and less administrative capacity to navigate the intricate compliance requirements.

Highly Compensated Employee (HCE) vs. Key Employee

While both highly compensated employees (HCEs) and key employees are IRS classifications important for retirement plan compliance, they serve different purposes and have distinct definitions.

Understanding the distinction is vital for employers to properly administer their retirement plans and maintain compliance with IRS regulations.

FAQs

What is the current compensation threshold for a Highly Compensated Employee (HCE)?

The compensation threshold for a highly compensated employee (HCE) is updated annually by the IRS. For the 2026 plan year, an employee is generally an HCE if they received more than $160,000 in compensation in 2025, or if they owned more than 5% of the business at any time during 2025 or 2026.

Why does the IRS limit 401(k) contributions for Highly Compensated Employees (HCEs)?

The IRS limits contributions for highly compensated employees (HCEs) to ensure that tax benefits associated with qualified retirement plans do not primarily benefit higher-paid individuals. This is part of non-discrimination testing, which aims to provide equitable access to retirement savings for all employees, regardless of their income level.

Can a Highly Compensated Employee (HCE) contribute the maximum to their 401(k)?

A highly compensated employee (HCE) may not always be able to contribute the maximum allowable amount to their 401(k) plan. Their contribution limits can be reduced if the plan fails its annual non-discrimination tests, which compare the average contribution rates of HCEs to those of non-highly compensated employees (NHCEs). If the HCE contributions are too high relative to NHCE contributions, HCEs may receive a refund of excess contributions.¹

What happens if a company's retirement plan fails non-discrimination testing because of Highly Compensated Employees (HCEs)?

If a company's retirement plan fails non-discrimination testing, it means the plan disproportionately favors highly compensated employees (HCEs). To correct this, the plan may need to take actions such as refunding excess contributions to HCEs, or making additional contributions to the accounts of non-highly compensated employees (NHCEs). Failure to correct discrimination issues can result in penalties for the employer.