Internal Revenue Service (IRS) rules require companies with 401(k) retirement plans to identify highly compensated employees (HCEs). An HCE, according to the IRS, passes either an ownership test or a compensation test. Someone owning more than 5% of the company would qualify as an HCE, as would someone who was compensated more than $135,000 for the 2022 tax year.
The IRS uses this information to help all employees receive fair treatment when participating in their 401(k). As a result, your HCE status can affect the amount you can contribute to your 401(k).
What Does It Mean to Be an HCE?
A highly compensated employee’s 401(k) contributions will be subject to additional scrutiny by the IRS. Again, you’re identified as an HCE if you either:
• Owned more than 5% of the business this year or last year, regardless of how much compensation you earned or received, or
• Received at least $135,000 in compensation for the 2022 tax year ($150,000 for 2023) and, if your employer so chooses, you were in the top 20% of employees ranked by compensation.
If you meet either of these criteria, you’re considered an HCE, though that doesn’t necessarily mean that you earn a higher salary.
For example, someone could own 6% of a business while also drawing a salary of less than $100,000 a year. Because they meet the ownership test, they would still be classified as an HCE.
It’s also possible for you to be on the higher end of your company’s salary range and yet not qualify as an HCE. This can happen if your company chooses to rank employees by pay. If your income is above the IRS’s HCE threshold but you still earn less than the highest-paid 20% of employees (while not owning 5% of the company), you don’t meet the definition of an HCE.
Highly Compensated Employee vs Key Employee
Highly compensated employees may or may not also be key employees. Under IRS rules, a key employee meets one of the following criteria:
• An officer making over $200,000 for 2022 ($215,000 for 2023)
• Someone who owns more than 5% of the business
• A person who owns more than 1% of the business and also makes more than $150,000 a year
• Someone who meets none of these conditions is a non-key employee.
In order for a highly compensated employee to be a key employee, they must pass the ownership or officer tests. For IRS purposes, ownership is determined on an aggregate basis. For example, if you and your spouse work for the same company and each own a 2.51% share, then you’d collectively pass the ownership test.
Benefits of Being a Highly Compensated Employee
Being a highly compensated employee can offer certain advantages. Here are some of the chief benefits of being an HCE:
• Having an ownership stake in the company you work for may entail additional employee benefits or privileges, such as bonuses or the potential to purchase company stock at a discount.
• Even with a high salary, you can still contribute to your 401(k) retirement plan, possibly with matching contributions from your employer.
• You may be able to supplement 401(k) contributions with contributions to an individual retirement account (IRA) or health savings account (HSA).
There are, however, some downsides to consider if you’re under the HCE umbrella.
Disadvantages of Being a Highly Compensated Employee
Highly compensated employees are subject to additional oversight when making 401(k) contributions. If you’re an HCE, here are a few disadvantages to be aware of:
• You may not be able to max out your 401(k) contributions each year.
• Lower contribution rates could potentially result in a shortfall in your retirement savings goal.
• Earning a higher income could make you ineligible to contribute to a Roth IRA for retirement.
• Any excess contributions that get refunded to you will count as taxable income when you file your return.
| Benefits | Disadvantages |
|---|---|
| HCEs may get certain perks or bonuses. | 401(k) contributions may be limited. |
| Can still contribute to a company retirement plan. | Limits may make it more difficult to reach retirement goals. |
| Can still contribute to an IRA. | High earnings may make you ineligible to contribute to a Roth IRA. |
| Refunds of excess contributions could raise employee’s taxable income. |
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Nondiscrimination Regulatory Testing
The IRS requires employers to conduct 401(k) plan nondiscrimination compliance testing each year. The purpose of this testing is to ensure that highly compensated employees and non-highly compensated employees have a more level playing field when it comes to 401(k) contributions.
Employers calculate the average contributions of non-highly compensated employees when testing for nondiscrimination. Depending on the findings, highly compensated employees may have their contributions restricted in certain ways. If you aren’t sure, it’s best to ask someone in your HR department, or the plan sponsor.
If an employer reviews the plan and finds that it’s overweighted in favor of HCEs, the employer must take steps to correct the error. The IRS allows companies to do that by either making additional contributions to the plans of non-HCEs or refunding excess contributions back to HCEs.
401(k) Contribution Limits for HCEs
In theory, highly compensated employees’ 401(k) limits are the same as retirement contribution limits for other employees. For 2022, the limit is $20,500; it’s $22,500 for 2023. Employees age 50 and older can make an additional $6,500 in catch-up contributions for 2022, and $7,500 for 2023.
But, as noted above, these plans may be restricted for HCEs, so it’s wise to know the terms before you begin contributing.
Other Retirement Plan Considerations
For example, one thing to watch out for if you’re a highly compensated employee is the possibility of overfunding your 401(k). If your employer determines that you, as an HCE, have contributed more than the rules allow, the employer may need to refund some of that money back to you.
As mentioned earlier, refunded money would be treated as taxable income. Depending on the refunded amount, you could find yourself in a higher tax bracket and facing a larger tax bill. So it’s important to keep track of your contributions throughout the year so the money doesn’t have to be refunded to you.
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401(k) vs IRAs for HCEs
A highly compensated employee might consider a traditional or Roth IRA to supplement their 401(k) savings. Either kind of IRA lets you contribute money up to the annual limit and make qualified withdrawals after age 59 ½ without penalty.
However, income-related rules could constrain highly compensated employees in terms of funding both a 401(k) and a traditional or Roth IRA.
• An HCE’s contributions to a traditional IRA may not be fully tax-deductible if they or their spouse are covered by a workplace retirement plan. Phaseouts depend on income and filing status.
• Highly compensated employees may be barred from contributing to a Roth IRA. Eligibility phases out as income rises. For the 2023 tax year, people become ineligible when their MAGI exceeds $153,000 (if single) or $228,000 (if married, filing jointly).
The Takeaway
A highly compensated employee is generally someone who owns more than 5% of the company that employs them, or who received compensation of more than $135,000 in 2022 ($150,000 in 2023).
Being an HCE can restrict how much you’re able to save in your company’s 401(k); under certain circumstances the IRS may require the employer to refund some of your contributions, with potential tax consequences for you. Even so, HCEs may still be able to save and invest through other retirement accounts.
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FAQ
Does HCE income include bonuses?
The IRS treats bonuses as compensation for determining which employees are highly compensated. Overtime, commissions, and salary deferrals to a 401(k) account are also counted as compensation.
What is the difference between a key employee and a highly compensated employee?
A highly compensated employee is someone who passes the IRS’s ownership test or compensation test. A key employee is someone who is an officer or meets ownership criteria. Highly compensated employees can also be key employees.
Can you be a key employee and not an HCE?
It is possible to be a key employee and not a highly compensated employee in certain situations. For example, you might own 1.5% of the business and make between $150,000 and $200,000 per year, while not ranking in the top 20% of employees by compensation.
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