Highly Compensated Employee (HCE)
A highly compensated employee (HCE) is, according to the Internal Revenue Service, anyone who has done one of the following: Owned more than 5% of the interest in a business at any time during the year or the preceding year, regardless of how much compensation that person earned or received Received compensation from the business of more than $130,000 if the preceding year is 2020 or 2021, and, if the employer so chooses, was in the top 20% of employees when ranked by compensation A highly compensated employee is defined as an employee that owns more than 5% of the interest in a business at any time during the year or the preceding year. By examining the contributions made by HCEs, the federal government compliance test determines whether all employees are treated equally through the company’s 401(k) plan. How much an HCE can contribute to their own retirement plans depends on the level of non-HCEs participation in the plan. A highly compensated employee (HCE) is, according to the Internal Revenue Service, anyone who has done one of the following: Owned more than 5% of the interest in a business at any time during the year or the preceding year, regardless of how much compensation that person earned or received Received compensation from the business of more than $130,000 if the preceding year is 2020 or 2021, and, if the employer so chooses, was in the top 20% of employees when ranked by compensation A highly compensated employee is defined as an employee that owns more than 5% of the interest in a business at any time during the year or the preceding year. By examining the contributions made by HCEs, the federal government compliance test determines whether all employees are treated equally through the company’s 401(k) plan. How much an HCE can contribute to their own retirement plans depends on the level of non-HCEs participation in the plan. In simpler terms, 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. The interest owned by an individual also includes the interest attributed to his or her relatives such as spouse, parents, children, grandchildren, but not grandparents or siblings. An employee with exactly 5% ownership in the company is not considered a highly compensated employee, whereas one with a 5.01% interest in the company has the HCE status. 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.
What Is a Highly Compensated Employee (HCE)?
A highly compensated employee (HCE) is, according to the Internal Revenue Service, anyone who has done one of the following:
Understanding Highly Compensated Employees (HCE)
Tax-deferred retirement plans such as 401(k) plans were implemented by the Internal Revenue Service (IRS) to offer equal benefits to all workers. Initially, all employees could contribute as much as they want, with total contribution matched by the employer up to $19,500 annually for 2020 and 2021.
High earners could contribute much more than other employees and were thus likely to benefit more from the tax-free plan, which allowed them to lower their tax liabilities considerably. Seeing that not all employees were receiving equal benefits from retirement plans, the IRS set rules against high earners contributing over a certain limit based on the average contribution of the other employees.
Nondiscrimination Test
The Internal Revenue Service (IRS) requires that all 401(k) plans take a nondiscrimination test every year. The test separates employees into two groups — non-highly compensated and highly compensated employees (HCE). 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 non-discrimination stipulations are set in place so that employee retirement plans do not discriminate in favor of highly compensated employees. Defining highly compensated employees provided a way for the IRS to regulate deferred plans and ensure that companies were not just setting up retirement plans to benefit their executives.
The 5% threshold is based on voting power or the value of company shares. The interest owned by an individual also includes the interest attributed to his or her relatives such as spouse, parents, children, grandchildren, but not grandparents or siblings. An employee with exactly 5% ownership in the company is not considered a highly compensated employee, whereas one with a 5.01% interest in the company has the HCE status. For example, an employee with 3% holdings in the company will be considered an HCE if his spouse owns 2.2% interest in the same company (total interest is 5.2%).
Special Considerations
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 employees’ contributions.
How much an HCE can contribute to their own retirement plans depends on the level of non-HCEs participation in the plan.
In simpler terms, 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 the employer fails to correct the discrimination, the plan could lose its tax-qualified status and 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 could make distributions to the HCE group, which will have to make withdrawals from the plan and pay taxes on the withdrawals.
Related terms:
403(b) Plan
A 403(b) plan is similar to a 401(k) but is designed for certain employees of public schools and tax-exempt organizations among other differences. read more
Actual Deferral & Actual Contribution Percentage Tests
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests assure that 401(k) plans don't favor higher-paid employees. read more
Double Advantage Safe Harbor (DASH) 401(k)
The Double Advantage Safe Harbor (DASH) 401(k) maximizes tax efficiency by stacking several tax code provisions. read more
Deferred Compensation
Deferred compensation is when part of an employee's pay is held for disbursement at a later time, usually providing a tax deferred benefit to the employee. read more
Defined-Contribution Plan
A defined-contribution plan is a retirement plan in which employees contribute part of their paychecks to an account intended to fund their retirements. read more
Nonqualified Plan
A nonqualified plan is a tax-deferred, employer-sponsored retirement plan that falls outside of Employee Retirement Income Security Act guidelines. read more
Nondiscrimination Rule
A nondiscrimination rule states that all employees of a company are able to receive the same benefits, regardless of their position within the company. read more
Tax Deferred
Tax-deferred status refers to investment earnings that accumulate tax free until the investor takes constructive receipt of the gains. The most common types of tax-deferred investments include individual retirement accounts (IRAs) and deferred annuities. read more