Highly compensated employees: Meaning, Criticisms & Real-World Uses

What Is Highly Compensated Employees?

Highly compensated employees (HCEs) are a specific classification of employees defined by the Internal Revenue Service (IRS) primarily for the purpose of ensuring fair and equitable distribution of employee benefits and retirement plans. This designation falls under the broader financial category of Employee Benefits and Compensation. The classification helps prevent tax benefits associated with qualified plans from disproportionately favoring higher-earning individuals over the general workforce. The concept of highly compensated employees is central to compliance with nondiscrimination testing rules for various employer-sponsored benefit programs. An employee's status as an HCE is determined annually based on specific criteria related to their ownership in the business or their compensation from the business⁵¹.

History and Origin

The concept of highly compensated employees arose from the need to regulate employer-sponsored benefit plans, particularly 401(k) plans, to ensure they do not unfairly favor a small group of highly paid individuals. Before such regulations, it was possible for employers to design plans that primarily benefited owners and top executives, leaving rank-and-file employees with minimal or no benefits.

The Employee Retirement Income Income Security Act (ERISA) of 1974 laid the foundational framework for regulating private sector employee benefit plans, setting minimum standards to protect individuals participating in these plans⁴⁹, ⁵⁰. The IRS, responsible for enforcing the Internal Revenue Code (IRC), developed specific definitions and nondiscrimination requirements in conjunction with ERISA to prevent such favoritism⁴⁷, ⁴⁸. The HCE classification is a key component of these rules, evolving over time with periodic adjustments to the compensation thresholds to reflect economic changes. These rules aim to ensure that all employees can equally benefit from their retirement plans⁴⁵, ⁴⁶. The Department of Labor (DOL) and the IRS share responsibility for enforcing these parallel provisions⁴⁴.

Key Takeaways

A highly compensated employee (HCE) is defined by the IRS based on ownership percentage or prior-year compensation.
The HCE designation is crucial for nondiscrimination testing of employer-sponsored qualified retirement plans, such as 401(k)s.
Nondiscrimination rules aim to prevent benefit plans from disproportionately favoring higher-paid employees over the general workforce.
If a plan fails nondiscrimination tests due to HCE contributions being too high relative to other employees, corrective actions may be required.
The compensation threshold for HCE status is adjusted annually by the IRS.

Formula and Calculation

An individual is generally classified as a highly compensated employee (HCE) for a given plan year if they meet either of two tests in the preceding year:

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 the amount of compensation received⁴², ⁴³. For example, if an employee owns 5.01% of a company, they are considered an HCE.
Compensation Test: The employee received compensation from the business exceeding a specific dollar amount in the preceding year, AND, if the employer elects, was in the top 20% of employees when ranked by compensation⁴⁰, ⁴¹. For the 2025 tax year, this threshold is $160,000 (up from $155,000 in 2024)³⁹.

Compensation for this purpose typically includes all taxable wages, salaries, bonuses, commissions, and elective deferrals to plans like 401(k)s and cafeteria plans³⁸.

Interpreting the Highly Compensated Employee

The classification of a highly compensated employee is not merely a label but a critical determinant for how certain retirement plans and other employer-sponsored benefits are structured and administered. The primary implication lies in nondiscrimination testing, which ensures that qualified plans provide benefits equitably across all employee groups, not just those with higher compensation.

For instance, in 401(k) plans, the IRS requires annual tests—such as the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test—to compare the average deferral and contribution rates of HCEs against those of non-highly compensated employees (NHCEs). If³⁶, ³⁷ HCEs contribute disproportionately more, the plan might fail these tests, necessitating adjustments that could include returning excess contributions to HCEs or making additional contributions for NHCEs. Th³⁵is framework encourages employers to promote broad employee participation and savings within their plans, reinforcing the intent of offering tax benefits to qualified arrangements.

Hypothetical Example

Consider "Tech Solutions Inc.," a company with 100 employees. For the 2025 plan year, the IRS highly compensated employee compensation threshold is $160,000.

Employee A earns $170,000 in compensation for the 2024 tax year and is among the top 20% of earners at Tech Solutions Inc. Employee A is an HCE based on the compensation test.
³⁴ Employee B earns $80,000 in compensation for the 2024 tax year but owns 6% of Tech Solutions Inc. Employee B is an HCE based on the ownership test, regardless of their lower salary.
³², ³³ Employee C earns $150,000 in compensation for the 2024 tax year and owns 2% of Tech Solutions Inc. Employee C is not an HCE because their compensation is below the $160,000 threshold, and their ownership is below 5%.

If Tech Solutions Inc. operates a 401(k) plan, the contributions of Employees A and B would be included in the HCE group for annual nondiscrimination testing, impacting how much they, and other HCEs, can contribute without jeopardizing the plan's qualified status. The rules governing the eligibility for and accumulation of benefits often involve concepts like vesting, which dictates when an employee gains full ownership of employer contributions.

Practical Applications

The classification of highly compensated employees is critical across several financial and regulatory domains:

Qualified Retirement Plans: The primary application of the HCE definition is in nondiscrimination testing for qualified plans like 401(k) plans, profit-sharing plans, and defined benefit plans. These tests, such as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, ensure that employer contributions and employee deferrals do not disproportionately favor HCEs over non-highly compensated employees (NHCEs). Fa²⁹, ³⁰, ³¹ilure to pass these tests can lead to corrective actions, including returning excess contributions to HCEs or making additional employer contributions to NHCEs. Th²⁸is compliance is essential for maintaining the plan's tax-advantaged status.
Executive Compensation Disclosure: While distinct from the HCE definition for retirement plans, publicly traded companies are required by the Securities and Exchange Commission (SEC) to disclose detailed information about their executive compensation for the principal executive officer, principal financial officer, and the three other most highly compensated executive officers. Th²⁶, ²⁷is disclosure appears in annual reports (Form 10-K) and proxy statement filings, providing transparency to investors about pay practices. Th²⁵e SEC's role in executive compensation focuses on disclosure requirements to aid investor decisions, not on setting the compensation itself.
²³, ²⁴ Employee Stock Ownership Plans (ESOPs): In some contexts, the rules governing employee stock ownership plans (ESOPs) may also reference or be influenced by concepts of highly compensated individuals, ensuring that the benefits of ownership are distributed broadly among employees.

Limitations and Criticisms

While the highly compensated employee (HCE) classification aims to promote fairness in employee benefits, it also presents certain limitations and criticisms:

Complexity of Compliance: The nondiscrimination testing required due to the HCE designation can be complex and administratively burdensome for employers, especially smaller businesses. Mi²²sclassification of employees or errors in testing can lead to plan disqualification and penalties from the Internal Revenue Service. So²¹me companies opt for "safe harbor" 401(k) plans to bypass some of these complex tests, which typically involve mandatory employer contributions.
¹⁹, ²⁰ Potential for Contribution Limits: Paradoxically, the rules designed to encourage broad participation can sometimes limit the ability of highly compensated employees to maximize their contributions to retirement plans. If NHCE participation is low, HCEs may have their elective deferrals restricted to ensure the plan passes the ADP test. Th¹⁷, ¹⁸is can be a point of contention for HCEs seeking to maximize their long-term savings.
Focus on Compensation: The sole reliance on compensation and ownership thresholds for HCE status might not always capture the full intent of an employee's impact or role within a company, potentially overlooking other factors that contribute to their overall value.
Evolving Regulatory Landscape: The regulatory environment, particularly concerning fiduciary duty and employee benefits, continues to evolve. For example, recent changes by the Department of Labor expanding who qualifies as an investment advice fiduciary under ERISA highlight the ongoing scrutiny and adjustments to ensure fair practices in retirement plans. Th¹⁶is constant evolution requires continuous monitoring by employers and plan administrators.

Highly Compensated Employees vs. Key Employee

While both "highly compensated employee" (HCE) and "Key employee" are classifications used by the Internal Revenue Service for qualified retirement plans, they serve distinct purposes and have different criteria.

Feature	Highly Compensated Employee (HCE)	Key Employee
Purpose	Primarily for nondiscrimination testing (e.g., ADP/ACP tests) to ensure plans don't favor higher earners.	¹⁵Primarily for "top-heavy" testing to determine if more than 60% of plan assets are held by key employees, which can trigger mandatory employer contributions for non-key employees.
¹³, ¹⁴	Compensation Test	Received more than $160,000 in compensation in the prior year (for 2025) AND, optionally, was in the top 20% by pay.
¹⁰, ¹¹	Ownership Test	Owned more than 5% of the business at any time during the current or prior year. ⁹
Overlap	All key employees are generally HCEs, but not all HCEs are key employees. ⁶, ⁷	A narrower definition; focuses on owners, officers, and very high earners.

The distinction is important because a plan can be "top-heavy" even if it passes nondiscrimination testing, leading to different compliance requirements.

FAQs

What is the current compensation threshold for a highly compensated employee?

For the 2025 tax year, an employee is generally considered a highly compensated employee if they received more than $160,000 in compensation during the preceding year (2024) and, if the employer chooses, were in the top 20% of employees by pay. Alternatively, anyone who owned more than 5% of the business at any time in the current or preceding year is also an HCE, regardless of their compensation.

#⁵## Why does the IRS classify employees as highly compensated?

The Internal Revenue Service classifies employees as highly compensated to ensure that qualified retirement plans, like 401(k) plans, provide fair benefits to all employees. This prevents plans from being structured in a way that disproportionately benefits owners and higher-paid individuals, thus preserving the plan's tax benefits and qualified status through nondiscrimination testing.

#³, ⁴## How do highly compensated employees affect a company's 401(k) plan?

Highly compensated employees directly impact a company's 401(k) plan through nondiscrimination testing. The IRS requires annual tests (e.g., ADP and ACP tests) that compare the average deferral and contribution rates of HCEs to those of non-highly compensated employees. If HCEs contribute too much relative to other employees, the plan might fail these tests, which could lead to HCEs receiving a refund of their excess contributions or the employer making additional contributions for the non-highly compensated employees to balance the averages.¹, ²