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

What Are Non-Highly Compensated Employees (NHCEs)?

Non-highly compensated employees (NHCEs) are a category of employees defined by the Internal Revenue Service (IRS) as those who do not meet specific criteria for being designated as highly compensated employees (HCEs). This distinction is fundamental in the realm of retirement plan compliance, particularly for qualified retirement plans like 401(k) plans-plans) and profit-sharing plans. The classification of employees into NHCEs and HCEs is crucial for employers to ensure their employee benefit plans adhere to federal nondiscrimination testing rules. These regulations aim to prevent retirement plans from disproportionately favoring higher-paid employees and to ensure equitable access to employee benefits and associated tax benefits for all eligible employees.

History and Origin

The concept of distinguishing between different employee groups for retirement plan purposes traces its roots back to early tax laws. Prior to comprehensive legislation, there were concerns that tax-advantaged retirement plans could be structured primarily to benefit business owners and high-income earners, potentially leaving lower-paid employees with inadequate or no retirement savings. To address these disparities and promote broader coverage, the Revenue Act of 1942 introduced stricter participation and disclosure requirements for pension plans.¹⁰

The modern framework for NHCEs and HCEs was significantly solidified with the enactment of the Employee Retirement Income Security Act (ERISA)) in 1974. ERISA established comprehensive regulations for private-sector retirement plans, including minimum funding standards, vesting schedules, and, crucially, nondiscrimination rules.⁹ The intent of these rules, particularly those found in Internal Revenue Code (IRC) Section 414(q), was to ensure that retirement plans provided meaningful benefits for a broad cross-section of a company's workforce, not just a select few. The IRS periodically updates the thresholds and rules, ensuring the regulations remain relevant in changing economic landscapes.⁸

Key Takeaways

NHCEs are employees who do not meet the IRS definitions for Highly Compensated Employees (HCEs) based on ownership or compensation thresholds.
Their classification is essential for employers to comply with annual nondiscrimination testing for qualified retirement plans.
Nondiscrimination rules aim to prevent employee benefit plans from disproportionately favoring HCEs over NHCEs, ensuring equitable access to plan benefits.
If a plan fails nondiscrimination tests, corrective actions are required, which may include returning excess contributions to HCEs or making additional contributions to NHCEs.
Understanding NHCE status is vital for employers in designing and maintaining compliant and effective retirement and compensation strategies.

Formula and Calculation

While there isn't a direct "formula" for calculating an NHCE's status, their classification is a residual of the criteria for a Highly Compensated Employee). An employee is an NHCE if they do not meet either of the following conditions for the prior year (or current year for the ownership test):

Ownership Test: Did not own more than 5% of the interest in the business at any time during the current or preceding year.,⁷
Compensation Test: Did not receive compensation from the employer exceeding a specific annual dollar threshold set by the IRS, and, if the employer elects, was not in the top 20% of employees when ranked by compensation.,⁶ For example, the compensation threshold was $155,000 for 2024 and increased to $160,000 for 2025.

The determination of NHCEs is crucial for various nondiscrimination tests, such as the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test. These tests compare the average deferral or contribution rates of HCEs to those of NHCEs.

For the ADP test, the formula for an individual's deferral percentage is:

\text{Individual Deferral Percentage} = \frac{\text{Employee's Elective Deferrals}}{\text{Employee's Compensation}}

The average deferral percentage is calculated for both the HCE group and the NHCE group, and then compared. Similarly, the ACP test applies to employer matching and after-tax contributions. The acceptable difference between the HCE and NHCE percentages is often limited to specific IRS guidelines, typically allowing the HCE group's average percentage to be no more than 1.25 times the NHCE group's average, or no more than two percentage points higher, whichever is greater.⁵

Interpreting the NHCE Status

The status of being a non-highly compensated employee is not merely a label; it carries significant implications for an employer's qualified retirement plan. The total number and participation rates of NHCEs directly influence whether a plan passes its annual nondiscrimination tests. A healthy level of participation and contribution among NHCEs is critical for a plan's continued tax-favored status.

For instance, if NHCEs contribute very little to their 401(k)s, it can restrict how much HCEs can contribute, potentially requiring HCEs to receive refunds of excess salary deferrals or employer matching contributions. Conversely, robust participation by NHCEs in a defined contribution plan provides greater flexibility for HCEs to maximize their contributions. Employers often analyze NHCE participation to identify areas for improvement, such as offering financial literacy education or adjusting plan design to encourage greater savings among this group.

Hypothetical Example

Consider "Tech Innovations Inc.," a growing software company with 100 employees. For the 2024 plan year, the IRS compensation threshold for an HCE is $155,000.

Sarah, a software developer, earned $90,000 in 2024 and owns no part of the company. She is an NHCE.
David, a senior engineer, earned $160,000 in 2024 but is not in the top 20% of the highest-paid employees and owns no part of the company. He is also an NHCE.
Maria, the VP of Marketing, earned $200,000 in 2024 and is in the top 20% of employees by compensation. She is an HCE.
John, the CEO, earned $300,000 and owns 10% of the company. He is an HCE.

Tech Innovations Inc. offers a 401(k) plan with an employer match. To determine if their plan passes the Actual Deferral Percentage (ADP) test for 2024, they calculate the average deferral rates for their HCEs and NHCEs.

Assume the average deferral percentage for all NHCEs at Tech Innovations Inc. for 2024 is 4%. Based on IRS rules, the average deferral percentage for HCEs cannot exceed 6% (4% + 2%, or 4% * 1.25, whichever is greater). If the HCE group's average deferral percentage is found to be, say, 7%, the plan would fail the ADP test. In this scenario, Tech Innovations Inc. would need to take corrective action, such as returning some of the excess contributions to Maria and John, or making additional contributions to the NHCEs to bring the averages into compliance. Encouraging greater employee participation among NHCEs helps prevent such failures.

Practical Applications

The identification and monitoring of non-highly compensated employees are central to the administration of employee pension plans and other benefit programs. Employers, especially those sponsoring tax-qualified retirement plans, must regularly assess the demographic and contribution patterns of their NHCE population.

One key practical application is in the design of safe harbor 401(k)) plans. These plans offer certain design features, such as specific employer contributions or matching formulas, that automatically satisfy certain nondiscrimination tests, thereby reducing the administrative burden of annual testing related to NHCE and HCE contributions. This can be particularly beneficial for smaller businesses or those with high HCE participation rates.

Furthermore, human resources and finance departments use NHCE data to formulate strategies for increasing plan participation and financial literacy among their broader workforce. This can involve enhancing communication about plan benefits, simplifying enrollment processes, or adjusting employer contribution schedules. The goal is to encourage greater savings among NHCEs, which in turn helps ensure the plan's compliance and allows HCEs to maximize their own contributions. Companies failing these nondiscrimination tests may face penalties and are required to take corrective measures, which can include distributing taxable refunds to HCEs.⁴

Limitations and Criticisms

While the framework of non-highly compensated employees and nondiscrimination testing is designed to ensure fairness, it is not without limitations or criticisms. One common issue is the administrative complexity of these rules, particularly for small and medium-sized businesses that may not have dedicated benefits professionals. Annual testing requires careful data collection and calculation, and errors can lead to time-consuming and costly corrections.

Another criticism is that the rules, while preventing overt discrimination, can sometimes limit the ability of higher-earning individuals to save optimally for retirement if NHCE participation is low. This might inadvertently push some high earners towards less tax-efficient savings vehicles outside the retirement savings plan. Despite efforts to encourage NHCE participation through plan design or education, factors like lower disposable income among NHCEs can naturally lead to lower contribution rates, creating a persistent challenge for plan sponsors. This dynamic can force companies to refund HCE contributions or make additional contributions to NHCEs, which can be an unexpected financial burden.³

Non-Highly Compensated Employees (NHCEs) vs. Highly Compensated Employees (HCEs)

The primary distinction between Non-Highly Compensated Employees (NHCEs) and Highly Compensated Employees (HCEs)) lies in specific thresholds related to ownership and compensation as defined by the IRS for retirement plan compliance. Essentially, an NHCE is any employee who does not meet the criteria to be classified as an HCE.

The distinction is critical because HCEs are subject to stricter limitations on their contributions to qualified retirement plans. These limitations are directly tied to the average contribution rates of the NHCE group through annual nondiscrimination tests. If HCEs contribute disproportionately more than NHCEs, the plan may fail these tests, necessitating corrective action. In essence, NHCEs represent the baseline against which the contributions of HCEs are measured to ensure the plan's tax-qualified status and adherence to the principle of broad employee benefit coverage.

FAQs

What is the main purpose of distinguishing between NHCEs and HCEs?

The main purpose is to ensure that employer-sponsored retirement plans do not disproportionately favor higher-paid employees. This is achieved through nondiscrimination testing, which compares the participation and contribution rates of Highly Compensated Employees (HCEs) against those of Non-Highly Compensated Employees (NHCEs).

How does an employee become classified as an NHCE?

An employee is classified as an NHCE if they do not meet the Internal Revenue Service's (IRS) definition of a Highly Compensated Employee (HCE). This generally means they did not own more than 5% of the business at any time during the current or preceding year, and their compensation for the preceding year was below the IRS-set annual threshold (e.g., $160,000 for 2025), and they were not in the top 20% of employees by compensation if the employer makes that election.

What happens if a company's retirement plan disproportionately favors HCEs over NHCEs?

If a company's retirement plan fails its annual nondiscrimination tests because Highly Compensated Employees (HCEs) contribute too much relative to Non-Highly Compensable Employees (NHCEs), the company must take corrective action. This typically involves returning excess contributions to HCEs or making additional, non-elective contributions to NHCEs' accounts to bring the averages into compliance.² Failure to correct these issues can result in penalties and the plan losing its tax-qualified status.

Can a company avoid nondiscrimination testing involving NHCEs and HCEs?

Yes, some companies can avoid certain annual nondiscrimination tests by adopting a "safe harbor" plan design. A safe harbor 401(k) plan) typically requires the employer to make certain minimum contributions to all eligible employees, including NHCEs, regardless of whether they contribute themselves. This design helps ensure broad participation and automatically satisfies some of the IRS's nondiscrimination requirements.¹