Highly compensated employees hces

What Are Highly Compensated Employees (HCEs)?

Highly compensated employees (HCEs) are a classification of employees, as defined by the Internal Revenue Service (IRS), who meet specific criteria related to their ownership stake in a company or their annual compensation. This designation is crucial within the realm of [Retirement Planning and Benefits], particularly for employers sponsoring tax-qualified retirement plans like a 401(k). The IRS establishes this classification to ensure that tax-advantaged retirement plans do not disproportionately benefit an organization's higher-earning or ownership-level staff over its general workforce. The rules governing highly compensated employees are designed to enforce fairness and prevent discrimination in benefit offerings.

History and Origin

The concept of highly compensated employees and the regulations surrounding their participation in company benefits stem from the Employee Retirement Income Security Act (ERISA) of 1974. ERISA is a federal law that sets minimum standards for most voluntarily established private-sector pension and health plans to provide protection for individuals in these plans. ERISA aims to protect the interests of plan participants and their beneficiaries by requiring disclosure of financial and other information, establishing standards of conduct for plan fiduciaries, and providing for enforcement of its provisions.

A key aspect of ERISA, and subsequently reinforced by IRS regulations, is the requirement for nondiscrimination testing for qualified retirement plans. These tests, such as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, were introduced to prevent situations where tax benefits primarily accrued to higher-earning individuals. The IRS periodically updates the compensation thresholds that define a highly compensated employee to account for inflation and economic changes, ensuring the continued relevance and application of the nondiscrimination rules.

Key Takeaways

• Highly compensated employees (HCEs) are defined by specific ownership or compensation thresholds set by the IRS.
• The HCE classification primarily impacts an individual's participation and contribution limits in tax-qualified employer-sponsored retirement plans.
• Employers must perform annual nondiscrimination tests, like ADP and ACP tests, to ensure their retirement plans do not unfairly favor HCEs.
• If a plan fails nondiscrimination testing, corrective measures are required, which may include limiting HCE contributions or distributing excess contributions.
• The purpose of HCE rules is to promote equitable access to tax deferral benefits across all employee groups.

Formula and Calculation

The determination of highly compensated employees (HCEs) is based on one of two criteria for a given plan year, generally looking at the preceding year (often referred to as the "look-back year")²⁸, ²⁹:

1. Ownership Test: An employee is an HCE if they owned more than 5% of the interest in the business at any time during the current year or the preceding year. This includes direct ownership and ownership attributed through family members such as spouses, parents, children, or grandparents²⁷.
2. Compensation Test: An employee is an HCE if they received compensation above a certain dollar limit in the preceding year. For example, for the 2025 plan year, an employee is considered an HCE if they earned more than $155,000 in 2024²⁵, ²⁶. This threshold is adjusted annually by the IRS²⁴. Additionally, employers can elect to limit this group to the top 20% of employees when ranked by compensation, if stated in the plan document²¹, ²², ²³.

The compensation limit includes salary, wages, bonuses, commissions, overtime, and elective deferrals to plans like 401(k)s and cafeteria plans²⁰.

For plans subject to nondiscrimination testing, the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are crucial. These tests compare the average contribution rates of HCEs to those of non-highly compensated employees (NHCEs).

The ADP test is calculated as follows for each group (HCEs and NHCEs):

[
\text{ADP} = \frac{\text{Total Elective Deferrals for the Group}}{\text{Total Compensation for the Group}}
]

Similarly, the ACP test for employer matching contributions and after-tax employee contributions uses:

[
\text{ACP} = \frac{\text{Total Employer Match + After-Tax Contributions for the Group}}{\text{Total Compensation for the Group}}
]

To pass these tests, the average percentage for HCEs cannot exceed the average percentage for NHCEs by more than a certain amount (generally, the NHCE average plus 2 percentage points, or 125% of the NHCE average, whichever is greater)¹⁸, ¹⁹.

Interpreting the Highly Compensated Employee (HCE) Status

The classification of an employee as a highly compensated employee carries significant implications, primarily in the context of defined contribution plans like 401(k)s. This designation is not simply an honorific; rather, it triggers specific IRS regulations designed to prevent discrimination in favor of highly compensated individuals regarding plan contributions and benefits.

For employers, identifying HCEs is the first step in conducting annual nondiscrimination testing. These tests, namely the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, compare the average deferral and contribution rates of HCEs against those of non-highly compensated employees (NHCEs)¹⁷. If a company's retirement plan fails these tests, it indicates that HCEs are contributing disproportionately more, potentially leveraging greater tax benefits. In such scenarios, the plan sponsor must take corrective action to maintain the plan's qualified status. This often involves issuing refunds of excess contributions to HCEs or making additional contributions to NHCEs¹⁶.

For individual employees, being an HCE means that their ability to contribute the maximum allowable amount to their 401(k) may be restricted if the plan's overall participation by non-HCEs is low. This limitation aims to balance the scales, ensuring that the tax advantages offered by the plan are accessible and utilized by a broad base of employees, not just the top earners. Understanding one's HCE status is therefore critical for personal retirement planning and maximizing available savings opportunities.

Hypothetical Example

Consider "InnovateTech Solutions," a company with 100 employees and a calendar-year 401(k) plan. For the 2025 plan year, the HCE compensation threshold is $155,000 based on 2024 earnings.

1. Ownership Check: Sarah, the CEO, owns 10% of InnovateTech. She is an HCE regardless of her income. David, a software engineer, owns 2% of the company, but his spouse, who also works at InnovateTech, owns 3.5%. Due to family attribution rules, David is considered to own 5.5%, making him an HCE.
2. Compensation Check: In 2024, Mark, a senior project manager, earned $180,000. Assuming InnovateTech does not elect the "top 20% group" rule, Mark is an HCE because his 2024 compensation exceeded $155,000. Emily, a marketing director, earned $140,000 in 2024. If InnovateTech does elect the "top 20% group" rule, and Emily's salary places her within the top 20% of all compensated employees (excluding Sarah and David who are already HCEs by ownership), then she would also be classified as an HCE. If the company does not make this election, or if her salary falls outside the top 20%, she would be a non-highly compensated employee (NHCE).

For the 2025 plan year, InnovateTech's retirement plan administrator will aggregate the contributions of all identified HCEs (Sarah, David, and potentially Mark and Emily) and compare them to the contributions of the NHCEs using the Actual Deferral Percentage (ADP) test and Actual Contribution Percentage (ACP) test. If the HCE group's average deferral or contribution percentage is too high relative to the NHCE group, corrective action would be necessary.

Practical Applications

The classification of highly compensated employees is a cornerstone of retirement plan compliance for businesses across various sectors. Its primary practical application lies in ensuring the fairness and regulatory adherence of employer-sponsored 401(k) and other qualified retirement plans.

Companies utilize the HCE definition to perform mandatory annual nondiscrimination testing, such as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. These tests are vital for maintaining the tax-qualified status of the plan under the Internal Revenue Service (IRS) and the Employee Retirement Income Security Act (ERISA)¹⁴, ¹⁵. If a plan fails these tests, it can result in penalties, plan disqualification, and potential fiduciary liability for the employer.

Furthermore, the HCE designation influences individual contribution limits. While the IRS sets overall maximum contributions for 401(k) plans, an HCE's actual permissible contribution may be lower if the average participation rate of non-highly compensated employees is insufficient to pass the nondiscrimination tests¹³. This acts as an incentive for employers to encourage broader participation in their retirement plans among all employees, not just the highly compensated ones, thereby promoting greater financial security across the workforce. The IRS provides detailed guidance on the nondiscrimination requirements for 401(k) plans, emphasizing their importance in plan administration. Internal Revenue Service.

Limitations and Criticisms

While the highly compensated employee (HCE) rules are designed to promote fairness in retirement plan contributions and ensure that tax benefits are broadly distributed, they are not without limitations and criticisms. One common critique is the potential for HCEs to have their tax deferral opportunities curtailed, even if they are willing and able to contribute more to their retirement plan. This can occur when a company's non-highly compensated employees do not participate in the 401(k) plan at a high enough rate to satisfy the nondiscrimination tests, leading to required refunds of excess contributions for HCEs¹². Some argue that this penalizes high earners and discourages maximum retirement savings, potentially pushing them towards less tax-efficient savings vehicles.

Additionally, the complexity of determining HCE status, especially with the "top 20% group" election and family attribution rules, can be burdensome for employers. Businesses must carefully track employee compensation and ownership stakes, adding administrative overhead.

More broadly, the HCE rules, while addressing plan-level discrimination, do not fully resolve larger issues of income inequality. While they ensure equitable access to certain retirement benefits, they do not address the fundamental disparities in wages or wealth accumulation that exist in the economy. Research from the Federal Reserve, for instance, often discusses how various economic factors and even monetary policy can influence the distribution of income and wealth across different segments of the population⁹, ¹⁰, ¹¹. The HCE rules focus on specific employer-sponsored benefits rather than broader structural economic disparities.

Highly Compensated Employees (HCEs) vs. Key Employees

While both highly compensated employees (HCEs) and key employees are classifications used by the Internal Revenue Service (IRS) for retirement plan compliance, they serve different purposes and have distinct definitions. Understanding the difference is crucial for proper plan administration.

The primary area of confusion arises because both classifications involve ownership and compensation thresholds. However, the specific dollar limits differ, the ownership attribution rules can vary slightly, and most importantly, the regulatory tests they are used for (nondiscrimination vs. top-heavy) are distinct.

FAQs

Q1: What is the current compensation threshold for a Highly Compensated Employee (HCE)?

A1: For the 2025 plan year, an employee is generally considered a highly compensated employee if they earned more than $155,000 in 2024, or if they own more than 5% of the company at any time during 2024 or 2025. This compensation limit is adjusted annually by the Internal Revenue Service.⁴

Q2: Why does the IRS limit contributions for Highly Compensated Employees (HCEs)?

A2: The IRS limits contributions for highly compensated employees in retirement plans to ensure these plans do not unfairly benefit higher-paid employees. This is enforced through nondiscrimination testing, which compares the average contribution rates of HCEs to those of non-highly compensated employees. The goal is to ensure all employees have equitable access to the tax-advantaged benefits of the plan.³

Q3: What happens if a company's 401(k) plan fails the HCE nondiscrimination tests?

A3: If a company's 401(k) plan fails the Actual Deferral Percentage (ADP) or Actual Contribution Percentage (ACP) tests, the employer must take corrective action. Common solutions include refunding excess contributions to the highly compensated employees or making additional qualified non-elective contributions or qualified matching contributions to the accounts of non-highly compensated employees to bring their average participation percentages up. Failure to correct a failed test can result in the plan losing its tax-qualified status.²

Q4: Does owning a small percentage of a company automatically make someone an HCE?

A4: Yes, if an employee owns more than 5% of the interest in the business at any time during the current year or the preceding year, they are considered a highly compensated employee, regardless of their compensation amount. This ownership can include stock held directly or attributed through family relationships.¹