Non highly compensated employees: Meaning, Criticisms & Real-World Uses

What Are Non Highly Compensated Employees?

Non highly compensated employees (NHCEs) are a category of an organization's workforce defined by the Internal Revenue Service (IRS) primarily for the purpose of ensuring nondiscrimination testing in employee benefit plans, particularly qualified retirement plans. In essence, an NHCE is an employee who does not meet the specific criteria set by the IRS for being classified as a highly compensated employee (HCE) in the preceding year¹⁰. This distinction is fundamental within the realm of employee benefits and compliance, ensuring that tax-advantaged retirement plans do not disproportionately favor an employer's highest-earning individuals or owners.

History and Origin

The concept of distinguishing between highly compensated and non highly compensated employees arose from the need to prevent discrimination in employer-sponsored benefit plans. Before the mid-20th century, many retirement plans were designed in ways that could primarily benefit executives and owners, leaving average workers with less secure or nonexistent benefits. This imbalance led to the enactment of the Employee Retirement Income Security Act of 1974 (ERISA).⁹

ERISA was a landmark federal law designed to protect the interests of participants and their beneficiaries in employee benefit plans. It established minimum standards for most voluntarily established pension and health plans in private industry. One of ERISA's core principles was to mandate nondiscrimination in plan design and operation. To achieve this, the legislation and subsequent IRS regulations, specifically Internal Revenue Code Section 414(q), introduced the definitions of highly compensated employees and, by extension, non highly compensated employees. This framework aimed to ensure that all eligible employees, not just those with high compensation or ownership, could receive equitable access to and benefits from employer-sponsored plans.⁷, ⁸

Key Takeaways

Non highly compensated employees (NHCEs) are defined by the IRS as individuals who do not meet specific income or ownership thresholds for a highly compensated employee.
Their classification is crucial for employers to comply with federal nondiscrimination rules for retirement plans, such as 401(k) plans-plans).
Nondiscrimination testing ensures that tax-advantaged accounts do not favor high earners or business owners over the general workforce.
The IRS annually adjusts the compensation threshold used to identify highly compensated employees, impacting who is classified as an NHCE.

Interpreting the Non Highly Compensated Employees Category

The classification of employees as non highly compensated employees (NHCEs) is critical for employers offering retirement plans because it directly impacts the ability of highly compensated employees (HCEs) to maximize their employer contributions and deferrals into defined contribution plans. The intent behind this distinction, enshrined in IRS regulations, is to prevent retirement plans from being primarily used as tax shelters for high-income earners.

If a retirement plan is found to disproportionately benefit HCEs, it may fail nondiscrimination testing. Such a failure can result in adverse tax consequences for HCEs, including the taxation of their excess contributions. Therefore, employers often monitor the participation rates and contribution levels of non highly compensated employees to ensure that the plan maintains its qualified status and that all employees receive fair access to benefits.

Hypothetical Example

Consider "Tech Solutions Inc.," a company with 100 employees. For the 2024 plan year, the IRS highly compensated employee compensation threshold is $155,000.

Sarah, a marketing specialist, earned $75,000 in 2023. She does not own any part of Tech Solutions Inc.
Mark, a software engineer, earned $100,000 in 2023. He also does not have any ownership interest in the company.
The company's CEO, Jane, earned $250,000 in 2023 and owns 10% of the company.

Based on the IRS rules:

Jane is a highly compensated employee because her 2023 compensation exceeded $155,000 and she is a 5% owner.
Sarah and Mark are both non highly compensated employees. Their compensation for the prior year was below the $155,000 threshold, and neither is a 5% owner.

When Tech Solutions Inc. performs its annual compliance testing for its 401(k) plan, the participation and contribution rates of Sarah, Mark, and all other non highly compensated employees will be compared to those of Jane and other HCEs to ensure the plan remains fair and does not discriminate in favor of the highly compensated individuals.

Practical Applications

The classification of non highly compensated employees (NHCEs) has several critical practical applications in financial planning and regulation, primarily within the context of employer-sponsored benefit plans:

Retirement Plan Compliance: The most significant application is in satisfying nondiscrimination rules for qualified retirement plans. The IRS mandates annual testing, such as the Actual Deferral Percentage (ADP) test and Actual Contribution Percentage (ACP) test, which compare the average deferral and contribution rates of NHCEs to those of HCEs. This ensures that defined benefit plans and other retirement vehicles benefit a broad base of employees, not just the highly paid.
Plan Design and Administration: Employers must design their plans with NHCE participation in mind. This might involve offering incentives to NHCEs to encourage higher participation or contributions, such as attractive employer matching contributions or simpler enrollment processes. The U.S. Department of Labor's Employee Benefits Security Administration (EBSA) oversees these plans, enforcing rules that protect participant rights and ensure proper administration.⁵, ⁶
Employee Communication and Education: Effective communication with non highly compensated employees about their vesting schedules, investment options, and the benefits of plan participation is vital. High participation rates among NHCEs help a plan pass its nondiscrimination tests, allowing HCEs to maximize their contributions.
Payroll and Human Resources Functions: HR and payroll departments must accurately identify and track non highly compensated employees based on IRS guidelines. This involves monitoring employee compensation and ownership stakes annually, as these factors determine HCE status.

Limitations and Criticisms

While the distinction between highly compensated employees and non highly compensated employees serves the vital purpose of promoting equity in employee benefits, the system is not without its complexities and occasional criticisms.

One primary limitation is the administrative burden it places on employers. Companies must conduct annual nondiscrimination testing, which can be a complex and time-consuming process, requiring careful data collection and calculation. Failure to pass these tests can lead to corrective actions, such as returning excess contributions to highly compensated employees or making additional contributions for non highly compensated employees, which can be costly and inconvenient.

Another point of contention can arise from the definition of a highly compensated employee itself. The IRS's criteria, based on a fixed compensation threshold and top-paid group election (if applicable), can sometimes categorize individuals as HCEs who might not perceive themselves as such within a large organization, leading to confusion regarding contribution limits. The rules on family attribution, where an employee's ownership interest can include that of their spouse, children, parents, and sometimes grandchildren, further add to the complexity of identifying HCEs and, consequently, NHCEs.⁴

Some critics argue that while the nondiscrimination rules prevent overt bias, they can indirectly limit the ability of highly compensated employees to save for retirement in tax-advantaged plans, especially if non highly compensated employee participation is low. This can push higher earners to seek alternative, often less tax-efficient, savings vehicles. However, the overarching goal remains to ensure that the tax benefits associated with qualified retirement plans are broadly available and do not disproportionately favor a select few.

Non Highly Compensated Employees vs. Highly Compensated Employees

The distinction between non highly compensated employees (NHCEs) and highly compensated employees (HCEs) is fundamental to U.S. employee benefits law, particularly under ERISA and IRS regulations. These two categories are mutually exclusive: an employee is either an NHCE or an HCE. The primary difference lies in how they are defined by the IRS and the implications of that classification for qualified retirement plans.

An employee is generally considered a highly compensated employee (HCE) for a given plan year if, during the preceding year, they met one of two conditions:

They owned more than 5% of the company's interest at any time during the current or preceding year, regardless of their compensation.
Their compensation from the employer exceeded a specific dollar amount, which is adjusted annually by the IRS (e.g., $160,000 for 2025). Employers may also elect to limit HCEs by compensation to only the top 20% of employees based on pay.², ³

Conversely, a non highly compensated employee (NHCE) is simply any employee who does not meet either of these criteria. The existence of the NHCE category is crucial because the IRS requires employers to demonstrate that their retirement plans do not disproportionately favor HCEs over NHCEs through annual nondiscrimination testing. The participation and contribution rates of NHCEs directly influence the maximum allowable contributions for HCEs, effectively ensuring broad-based benefit access across the workforce.

FAQs

What is the primary purpose of classifying employees as non highly compensated?

The primary purpose is to ensure that employer-sponsored qualified retirement plans, such as 401(k) plans, do not discriminate in favor of highly compensated employees (HCEs) or owners. This classification helps in performing annual nondiscrimination testing required by the IRS.

How is a non highly compensated employee different from a regular employee?

A "regular employee" is a general term for anyone employed by a company. A "non highly compensated employee" (NHCE) is a specific classification under IRS rules for employee benefits, indicating that the individual does not meet the criteria to be considered a highly compensated employee (HCE) based on their ownership stake or compensation level. All employees are either an NHCE or an HCE for benefit plan purposes.

Does being a non highly compensated employee affect my benefits?

Not directly in a negative way. In fact, nondiscrimination rules are designed to protect non highly compensated employees (NHCEs) by ensuring they receive fair access to benefits in qualified plans. If too few NHCEs participate or contribute, it can limit the contributions that highly compensated employees can make, thereby incentivizing employers to encourage broader participation among NHCEs.

Are all part-time employees considered non highly compensated employees?

Not necessarily. While many part-time employees may fall into the non highly compensated employee category due to their lower compensation, their status depends entirely on whether they meet the specific IRS criteria for a highly compensated employee (HCE), which includes both compensation and ownership tests. An individual's classification is based on their prior year's pay and any ownership stake, not solely on their employment status (full-time vs. part-time).

Where can I find the current compensation threshold for highly compensated employees?

The IRS updates the compensation threshold for highly compensated employees annually. This information is typically released by the IRS towards the end of the year for the upcoming tax year and can be found on the IRS.gov website or through benefit plan administrators.¹