If your company offers retirement plan options, you have to ensure each employee can benefit equally from the plan. To do this, you must consider who is a highly compensated employee (HCE). Not familiar with highly compensated employees? No worries—we’ll go over the HCE definition, how to determine who is classified as a highly compensated employee, and more.
Highly compensated employee definition
So, who is a highly compensated employee? According to the IRS, a highly compensated employee is an individual who meets one of the following:
- Ownership test: 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
- Compensation test: Received compensation from the business of more than $150,000 if the preceding year is 2023 and, if the employer so chooses, was in the top 20% of employees when ranked by compensation
The interest is based on the value of shares of a business and includes the interest attributed to the employees, their spouses, their children, and their grandchildren in the same company. For example, if an employee owns 3% of the shares of a business and their spouse owns 2.5%, their total ownership adds up to 5.5%, which is above the 5% threshold.
Compensation includes regular recurring payments from employers, bonuses, commissions, overtime pay, etc.
An HCE limit can potentially change each year. To ensure you’re using the latest compensation limits, check the IRS’s website.
HCEs come into play when it comes to 401(k) retirement plans. The goal of having a highly compensated employee status is to ensure that all employees in a business can benefit equally from their retirement plans.
Ownership test example
Say your employee, Ashley, was a 10% owner of the plan sponsor in 2023. Since Ashley was at least a 5% owner during the preceding year, she is considered an HCE.
Compensation test example
Say your business establishes a retirement plan effective January 1, 2024. An employee’s compensation from the business during 2023 was $200,000. Because the preceding tax year is 2023 and the amount exceeds $150,000, the employee is considered an HCE.
When it comes to highly compensated employees, you may also stumble across the term “key employees.” So, what are key employees?
A key employee is an employee with major ownership and/or a decision-making role in a business. Key employees are usually highly compensated either with compensation or benefits. So, you must classify each employee accordingly.
Someone who is an HCE can also be a key employee. Key employees in 2024 must meet one of the following:
- Officer test: An officer of the company sponsoring the plan who receives actual compensation of $220,000 or more
- 5% owner test: An employee who owns more than 5% of the company or is directly related to someone who does.
- 1% owner test: An employee who owns more than 1% of the company and earns more than $150,000 (not adjusted for inflation).
Like with HCEs, you can use the specific tests above to find out if your employee is a key employee.
Knowing your business’s amount of key employees and HCEs can help you determine if you have a top-heavy retirement plan. A top-heavy plan is when the owners and most highly paid employees (or key employees) own more than 60% of the value of the plan assets.
Nondiscrimination test for retirement plans
Retirement plans must satisfy nondiscrimination tests to ensure that employers provide benefits equally to all employees (not just highly compensated or key employees). The nondiscrimination test ensures that HCEs do not overly utilize plans.
The testing requires that highly compensated employees and key employees stay within a specific contribution rate. Employers with traditional 401(k) plans must pass a nondiscrimination test each year.
You can use the following for nondiscrimination testing:
- Highly compensated employees
- Ownership test OR compensation test
- Key employees
- Officer test OR 5% owner test OR 1% owner test
Along with the above tests, you may also decide to use standard tests for traditional 401(k) plans. The standard tests include:
- ADP test
- ACP test
If you fail a nondiscrimination test, you need to fix the issue as soon as possible. If you don’t make changes, your plan could lose its tax-qualified status and all contributions will be redistributed to the plan’s participants. As an employer, you may also face financial and tax consequences.
Actual deferral percentage test
The actual deferral percentage test (ADP) looks at the average percentage of the salary that participating HCEs defer to the average percentage that non-highly compensated employees (NHCEs) defer. The percentage shows how engaged each employee is in the retirement plan.
For the ADP test, you must calculate two percentages:
- Annual HCE contribution rate: Put the HCEs together and calculate the average annual employee deferral rate as a percentage of their total compensation.
- Annual NHCE contribution rate: Put the NHCEs together and calculate the average annual employee deferral rate as a percentage of their total compensation.
The plan passes the ADP test if the average for the HCE group is within a certain spread of the NCHE average. According to the IRS, the highly compensated employees’ actual deferral percentage can’t exceed the greater of:
- 125% of the ADP for the group of nonhighly compensated employees
- The lesser of 200% of the nonhighly compensated employees’ ADP OR the ADP for the NHCEs, plus 2%
Actual contribution percentage test
The actual contribution percentage test (ACP) applies to businesses offering a 401(k) match or after-tax contributions.
The calculations and breakdowns are the same as the ADP test. However, they can include after-tax contributions and an employer match in the calculations. For example, factor in a 401(k) match (if applicable) when calculating an average contribution rate for HCEs and NHCEs.
Highly compensated employee 401(k): Fast facts
IRS highly compensated employee lingo, tests, etc. can be uber confusing, especially if you’re new to the whole entrepreneurship thing.
To make things easier, here’s a brief breakdown of the key points you need to know:
- HCEs come into play for retirement plans
- Understand who is a highly compensated employee to ensure you treat all employees equally through your business’s 401(k) plan
- A highly compensated employee either owns more than 5% of the interest in a business at any time during the year or the preceding year or receives compensation above a certain amount (subject to change each year)
- Employers with traditional 401(k) plans need to perform a nondiscrimination test each year
- HCEs may also be considered key employees (depending on if they meet the qualifications)
For more information on HCEs, nondiscrimination tests, and more, consult the IRS website.
This article is updated from its original publication date of June 7, 2012.This is not intended as legal advice; for more information, please click here.