What Is a Highly Compensated Employee (HCE)?
The Internal Revenue Service (IRS) defines a highly compensated employee (HCE) as one who meets either or both of the following standards:
- Owned more than 5% of the business at any time during the year or the preceding year, regardless of the amount of compensation received.
- Received more than $150,000 in compensation in the 2023 tax year and was in the company's top 20% in pay. In the 2024 tax year, the amount increases to $155,000.
Key Takeaways
- 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 as far as tax advantages go.
- 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. 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 the person's 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 $22,500 for 2023. The figures increase to $23,000 in 2024.
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.
To correct this disparity, the IRS set limits on the dollar amount of contributions that can be made by high earners.
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 are designed to make sure that the tax advantages of employee retirement plans do not disproportionately favor highly compensated employees.
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 receive compensation in 2024 that's more than $155,000 and you’re in the top 20% of employees as ranked by compensation, your employer can classify you as a highly compensated employee. 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 would have to be returned 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 its non-highly compensated employees. Or, the firm can make distributions from its retirement plans to the highly compensated employees, who would then have to pay taxes on the withdrawals.
401(k) Contribution Limits for Highly Compensated Employees
For 2023, highly compensated employees can contribute up to $22,500 to a 401(k) plan. If they’re age 50 or older, they can contribute an additional $7,500 catch-up amount.
In 2024, they can contribute up to $23,000, plus $7,500 as a catch-up contribution.
Other Retirement Savings Options for Highly Compensated Employees
Open an IRA
In addition to your 401(k), open a traditional IRA to add a pre-tax contribution of up to $6,500 in 2023. In 2024, the number rises to $7,000 and the $1,000 catch-up amount remains unchanged.
The deduction for contributions is reduced and ultimately phases 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 uncovered healthcare expenses, 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, including 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 $155,000 in compensation in the previous year, if that year is 2024 and the person ranked in the top 20% of employees by compensation. The numbers are revised annually by the IRS.
Why Is it Important to Know Whether I'm a Highly Compensated Employee?
If you are a highly compensated employee, the amount that the IRS allows you to contribute to your 401(k) plan is limited. If you contribute more than that amount, it would most likely be refunded 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 highly-paid employees over 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
When in doubt, ask your company's benefits 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.
