What Is a Highly Compensated Employee (HCE)?

What Is a Highly Compensated Employee?

According to the Internal Revenue Service (IRS), a highly compensated employee (HCE) is anyone who has met one of the following two standards:

  • Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received.
  • Received more than $130,000 in compensation in the previous year, if that year was 2021 (the amount applicable for 2022 is $135,000), and was in the top 20% of employees as ranked by compensation by the employer.

Key Takeaways

  • A highly compensated employee is an employee who owns more than 5% of the business during the current or preceding year.
  • The 401(k) plan contributions of an employee designated as highly compensated are limited by IRS regulation.
  • The IRS wants to ensure that the benefit of pre-tax contributions applies equally to all employees.
  • It requires that all 401(k) plans perform an annual nondiscrimination test to determine whether or not all employees are treated equally.
  • How much an HCE can contribute to their retirement plan depends on the level of non-HCE participation in the plan.

Understanding Highly Compensated Employees

The disadvantage of being classified as a highly compensated employee is that your 401(k) plan contributions are limited. That's because the IRS wants to make sure that the taxable income-lowering advantage offered by pre-tax contributions doesn't benefit one group of employees more than others.

The 5% threshold for HCEs mentioned above is based on voting power or the value of company shares. The interest owned by an individual also includes the interest held by relatives such as spouses, parents, children, and grandparents (but not grandchildren or siblings).

For example, an employee with exactly 5% ownership in the company is not considered a highly compensated employee. One with a 5.01% interest in the company has the HCE status. An employee with 3% holdings in the company will be considered an HCE if their spouse owns 2.2% interest in the same company (making the employee's total interest 5.2%).

Tax-deferred retirement plans such as 401(k) plans were implemented by the IRS to offer equal benefits to all workers. Initially, all employees could contribute as much as they wanted to, with the total contribution matched by the employer up to $19,500 annually for 2021 and $20,500 for 2022.

That meant high earners could contribute much more than other employees. Thus, they would benefit to a greater degree from the tax deductions that lower taxable income.

Seeing that not all employees were receiving equal benefits from retirement plans, the IRS set rules against high earners contributing over a certain limit that's based on the average contribution of the other employees.

Nondiscrimination Test

The IRS requires that all 401(k) plans perform a nondiscrimination test every year. The test separates employees into two groups: non-highly compensated and highly compensated employees. By examining the contributions made by HCEs, the compliance test determines whether all employees are treated equally through the company’s 401(k) plan.

The nondiscrimination stipulations exist so that employee retirement plan advantages do not favor highly compensated employees more than others. Defining highly compensated employees provided a way for the IRS to regulate deferred plans and ensure that companies were not setting up retirement plans to benefit their executives.

If the average contributions of HCEs to the plan are more than 2% higher than the average contributions of non-HCEs, the plan would fail the non-discrimination test.

In addition, contributions by HCEs as a group cannot be more than two times the percentage of other employee contributions.

If you received compensation in 2021 that's more than $130,000 and you’re in the top 20% of employees as ranked by compensation, then your employer can classify you as a highly compensated employee. This classification applies until the employer revokes it. Compensation includes overtime, bonuses, commissions and salary deferrals made toward cafeteria plans and 401(k)s.

Other Considerations

When a company contributes to a defined-benefit or defined-contribution plan for its employees and those contributions are based on the employee's compensation, the IRS requires that the company minimize the discrepancy between the retirement benefits received by highly compensated and lower compensated employees.

If an employer fails to correct a discrepancy, the plan is liable to lose its tax-qualified status. All contributions will have to be re-distributed to the plan’s participants. The employer could also face severe financial and tax consequences as a result of distributing the contributions and earnings.

A company can correct any imbalance in its retirement plans by making additional contributions for the non-highly compensated group of employees. Alternatively, the firm can make distributions to highly compensated employees (who would have to pay taxes on the withdrawals).

401(k) Contribution Limits for Highly Compensated Employees

For 2021, HCEs who are single filers of tax returns can contribute up to $19,500 to a 401(k) plan. For 2022, they can contribute up to $20,500. If they’re age 50 or older, they can contribute an additional $6,500 catch-up amount for a total of $$26,000 in 2021 and $27,000 in 2022.

Other Retirement Savings Options for Highly Compensated Employees

Open an IRA

In addition to your 401(k), open a personal IRA to add a pre-tax contribution of $6,000 in 2021 ($7,000 with the catch-up amount) to your tax-advantaged savings. The maximum allowed contribution amount for 2022 is the same.

The deduction for contributions is reduced (and ultimately phased out) if you (or your spouse) have a workplace retirement plan and your adjusted gross income is above a certain amount. However, you'll still be able to build your tax-deferred retirement savings.

Open a Health Savings Account (HSA)

If you have a high-deductible health plan (HDHP), consider opening a health savings account (HSA). While helping you save for future medical expenses (instead of withdrawing funds from your 401(k) to cover them), they also provide tax benefits.

You contribute pre-tax dollars to an HSA and your earnings grow tax-deferred. You can invest in a variety of securities including stocks, bonds, and mutual funds. Moreover, the money you withdraw from it is tax free (as long as it's used to pay for qualified medical expenses). 

Open a Brokerage Account

It may not be a tax-advantaged account, but it can help you build more savings. You can invest in all kinds of securities (even those with their own tax advantages such as Treasury bonds and municipal bonds). You can invest as much as you wish and take money out at any time.

Participate in a Deferred Compensation Plan

This type of plan allows you to defer a certain percentage of your salary and the taxes you'd pay on it, typically until after you retire. There are no limits to the amount you can defer and the investment options are similar to those available to a 401(k). You'll owe taxes on the plan payouts after you retire.

Bear in mind that a deferred compensation plan is an asset of the company. You don't own it, as you do your 401(k). If the company fails, you won't have access to the compensation you deferred.

What's a Highly Compensated Employee?

According to the IRS, a highly compensated employee is someone who either owned more than 5% of the interest in the business at any time during the year or the preceding year (regardless of how much compensation that person earned or received), or, received more than $130,000 in compensation in the previous year, if that year was 2021 and was ranked in the top 20% of employees by compensation by the employer.

Why Is it Important to Know Whether I'm a Highly Compensated Employee?

It's important to know because if you are, the amount that the IRS allows you to contribute to your 401(k) is officially limited. If you contribute more than that amount, it would most likely be distributed back to you and you'd owe taxes on it.

Why Does the IRS Limit Contributions for Highly Compensated Employees?

The IRS places limits on HSE contributions because it wants to ensure that the tax benefit of 401(k) contributions doesn't favor one group of employees more than others. If HSEs were able to make larger contributions compared to other employees, they'd be able to reduce their taxable income to a greater degree.

The Bottom Line

Be sure that you ask your Benefits or Human Resources department whether or not you're a highly compensated employee. Double-check on the amount you can contribute to your 401(k). You also want to be prepared to pay additional taxes on what you may have contributed in the previous year.

For example, if it turns out that you are an HCE and you contributed the maximum, there could be consequences. If your company fails the nondiscrimination test, it will probably refund you the excess contributions you made. This will be considered taxable income.

Article Sources
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  1. Internal Revenue Service. "Definitions."

  2. Internal Revenue Service. "401(k) Plan Fix-It Guide - The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests."

  3. Internal Revenue Service. "2022 Limitations Adjusted as Provided in Section 415(d), etc."

  4. Office of the Law Revision Counsel. "26 USC 414: Definitions and Special Rules."

  5. Internal Revenue Service. "Tax Consequences of Plan Disqualification."

  6. Internal Revenue Service. "Retirement Topics-IRA Contribution Limits."

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