What Is a Non Highly Compensated Employee?
A non highly compensated employee (NHCE) is an individual who does not meet the specific criteria set by the Internal Revenue Service (IRS) for classification as a Highly Compensated Employee (HCE). This distinction is critical in the realm of retirement plans and employee benefits, falling under the broader financial category of retirement plan compliance. The IRS defines NHCEs primarily for the purpose of enforcing non-discrimination testing rules, ensuring that tax-advantaged employer-sponsored plans, such as a 401(k)) plan, do not disproportionately favor highly paid individuals or company owners over the majority of the workforce.34, 35
History and Origin
The concept of distinguishing between highly compensated and non highly compensated employees arose from the need to prevent abuses in employer-sponsored retirement plans. Prior to the Employee Retirement Income Security Act of 1974 (ERISA), some private pension plans were subject to mismanagement and abuse, leading to concerns about the security of employees' retirement savings.33 ERISA was enacted to establish minimum standards for most private industry employee benefit plans, including pension plans.32 A core component of ERISA was the introduction of non-discrimination rules, which aimed to ensure that the tax benefits associated with qualified retirement plans were broadly available to all eligible employees, not just a select few.31
To enforce these rules, the IRS, which works in conjunction with the Department of Labor on ERISA administration, developed definitions for HCEs and NHCEs. These definitions, outlined in Internal Revenue Code Section 414(q) and detailed in publications like IRS Publication 560, establish thresholds for compensation and ownership interest to identify those employees who are considered "highly compensated." Consequently, anyone not meeting those thresholds is a non highly compensated employee.29, 30 This framework ensures that companies must encourage broad participation among all employees, including non highly compensated employees, for their retirement plans to maintain their tax-qualified status.27, 28
Key Takeaways
- Non highly compensated employees are individuals who do not meet the IRS's criteria for highly compensated employees based on compensation or ownership.
- Their classification is crucial for employers offering tax-advantaged defined contribution plans like 401(k)s to ensure regulatory compliance.
- Non-discrimination testing, mandated by ERISA and the IRS, relies on the distinction between HCEs and NHCEs to prevent plans from disproportionately benefiting higher earners.
- The participation rates and contributions of non highly compensated employees directly impact the contribution limits for highly compensated employees within a retirement plan.
- Maintaining a high participation rate among non highly compensated employees is vital for an employer's retirement plan to retain its tax-favored status and avoid penalties.
Interpreting the Non Highly Compensated Employee
The classification of a non highly compensated employee is not a judgment of an individual's value but rather a regulatory distinction used for compliance purposes in tax-deferred accounts and retirement planning. For employers, understanding who qualifies as a non highly compensated employee is paramount for managing their employee benefits programs. This distinction directly influences the design, administration, and ongoing compliance of qualified retirement plans. A key aspect is ensuring that the average contribution rates of NHCEs are sufficiently high to pass annual non-discrimination tests, such as the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test. If these tests fail, it can result in corrective distributions to HCEs or employer contributions to NHCEs to rebalance the plan and avoid penalties.
Hypothetical Example
Consider "Tech Solutions Inc.," a company with 100 employees. For the 2024 plan year, the IRS highly compensated employee threshold for compensation was $155,000.26
- Scenario: Tech Solutions Inc. has 10 employees who earned more than $155,000 in 2023 and two owners who each held more than 5% of the company at any point in 2023, regardless of their compensation. These 12 individuals are classified as highly compensated employees (HCEs).25
- The Non-Highly Compensated Employees: The remaining 88 employees, who neither earned more than $155,000 in 2023 nor held more than 5% ownership in the company, are categorized as non highly compensated employees.23, 24
- Implication: When Tech Solutions Inc. conducts its annual non-discrimination testing for its 401(k) profit-sharing plans, the average contribution rates of these 88 non highly compensated employees will be compared to the average contribution rates of the 12 HCEs. This comparison determines whether the plan adheres to IRS rules, which limit how much HCEs can contribute based on the participation level of NHCEs.
Practical Applications
The identification of non highly compensated employees is a foundational element in several practical aspects of employee benefits and financial regulation:
- Retirement Plan Compliance: The primary application is in ensuring that employer-sponsored retirement plans, such as 401(k)s, Simplified Employee Pension (SEP) plans, and SIMPLE IRAs, comply with IRS non-discrimination rules. These rules prevent plans from unduly favoring highly compensated individuals.22 Companies must monitor the participation and contribution rates of their non highly compensated employees to pass these crucial annual tests.
- Plan Design and Strategy: Employers often strategize on how to encourage greater participation among their non highly compensated employees. This can involve offering more generous employer matching contributions, improving financial literacy education, or simplifying enrollment processes. Such efforts are aimed at increasing the average contribution rate of NHCEs, which in turn allows HCEs to contribute more to their plans.20, 21
- Regulatory Reporting: Companies are required to submit regular reports to the IRS detailing their plan's compliance, which includes information segmented by highly compensated and non highly compensated employee groups. The IRS provides guidance on these requirements in documents such as IRS Publication 560, "Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans)."19
- Benefit Fairness: Beyond regulatory compliance, the distinction helps promote equitable access to tax-advantaged retirement savings opportunities for all employees, aligning with the spirit of ERISA.
Limitations and Criticisms
While the distinction between non highly compensated employees and highly compensated employees is essential for ensuring fairness in employer-sponsored retirement plans, some aspects can present challenges or invite criticism. One limitation is the administrative complexity for employers, particularly smaller businesses, in accurately identifying these groups and performing the required annual non-discrimination tests. The rules for determining HCE status, including "family attribution rules" (where ownership by family members can be attributed to an employee) and the "top 20% election" for compensation, can be intricate.17, 18
Another point of contention can be the impact on highly compensated employees. If the participation of non highly compensated employees is low, HCEs may face limits on their elective deferrals or employer contributions, which can be frustrating for those seeking to maximize their retirement savings.16 This dynamic can sometimes lead to discussions about whether the regulations overly penalize higher earners for the low participation of others, rather than focusing solely on incentives for broader engagement. Furthermore, while the rules aim for non-discrimination, the annual adjustment of compensation thresholds by the IRS can require ongoing vigilance from employers to ensure accurate classifications and compliance.14, 15
Non Highly Compensated Employee vs. Highly Compensated Employee
The primary distinction between a non highly compensated employee (NHCE) and a Highly Compensated Employee (HCE) lies in specific criteria defined by the IRS related to their compensation and ownership within a company.
| Feature | Non Highly Compensated Employee (NHCE) | Highly Compensated Employee (HCE) |
|---|---|---|
| Definition | An employee who does not meet the IRS's criteria for an HCE. They are typically the majority of a company's workforce.13 | An employee who meets one or both of the following criteria in the prior year (or current year for ownership): 1. Owned more than 5% of the business at any time during the year or preceding year. 2. Received compensation above a set annual threshold (e.g., $155,000 for 2024, $160,000 for 2025) AND, if the employer elects, was in the top 20% of employees by compensation.11, 12 |
| Purpose | Serves as the benchmark group for non-discrimination testing to ensure that tax-advantaged retirement plans do not disproportionately favor higher earners.10 | Identified to ensure their retirement plan contributions and benefits do not excessively exceed those of NHCEs, maintaining the plan's tax-qualified status. |
| Contribution Limits | Generally, their participation levels dictate the maximum allowed contributions for HCEs in certain retirement plans. Their contributions are typically only limited by the general IRS contribution limits for all participants. | Their ability to contribute to their 401(k) or similar plan may be limited if the plan fails non-discrimination tests, requiring adjustments to their contributions or additional contributions to NHCEs.9 |
| Significance | High participation and contribution rates from NHCEs are crucial for employers to maintain their retirement plan's tax benefits and avoid corrective actions.8 | Their plan contributions are subject to scrutiny during non-discrimination testing to ensure compliance with ERISA and IRS regulations.7 |
FAQs
1. Why is the distinction between highly compensated and non highly compensated employees important?
The distinction is crucial for employer-sponsored retirement plans to maintain their tax-qualified status with the IRS. It ensures that the tax benefits of these plans are available to a broad base of employees, not just a select group of high earners or owners. Employers must pass annual non-discrimination tests that compare the participation and contribution rates of both groups.6
2. How often do the compensation thresholds change for a highly compensated employee?
The compensation threshold for a Highly Compensated Employee is adjusted annually by the IRS for inflation. For instance, the threshold was $155,000 for the 2024 tax year and increased to $160,000 for 2025.4, 5
3. What happens if a company's retirement plan disproportionately favors highly compensated employees?
If a retirement plan fails its annual non-discrimination tests, indicating it disproportionately favors highly compensated employees, the IRS may require corrective action. This often involves refunding excess contributions to the HCEs (which then become taxable income) or making additional contributions for the non highly compensated employees to balance the plan. Failure to correct can result in the plan losing its tax-qualified status, leading to severe tax implications for both the employer and plan participants.
4. Are non highly compensated employees required to participate in a company's retirement plan?
Non highly compensated employees are generally not required to participate in an employer's qualified plan. However, their participation is highly encouraged and beneficial for both the employees (for their own retirement savings and vesting in employer contributions) and the employer (to help the plan pass non-discrimination testing).2, 3
5. Does this classification apply to all types of businesses?
Yes, the IRS definitions of highly compensated and non highly compensated employees apply to most private sector businesses that sponsor qualified retirement plans, such as 401(k)s. This ensures consistent application of non-discrimination rules across various company structures.1