The term highly compensated employee was coined by the government with the aim of regulating deferred savings programs within organizations. Professionals who own 5% or more of the company or receive more compensation than a predetermined limit are called highly compensated employees.
Why regulate deferred savings programs?
Categorizing employees as highly compensated and non-highly compensated helps the Internal Revenue Service (IRS) ensure that the company is not unfairly favorable to the former group. The term highly compensated employee is applicable to the top earners in a company.
In many retirement programs, individual employee contributions are matched by the company. Highly compensated employees can contribute much more than non-highly compensated employees. As such, they are likely to profit much more from the program.
For instance, a highly compensated employee may be able to contribute $120,000 to a plan annually, while the yearly contribution of a non-highly compensated employee may amount only to $25,000.
Before the rules for highly compensated employees came into effect, the top earners were free to contribute as much as they want. As money contributed to a retirement plan like 401k is tax-free, large contributions allowed the top earners to lower their tax liability considerably.
Moreover, the contribution was matched 100% up to $16,500 by the employer. This often resulted in a total contribution that was much higher than the entire annual salary of a low wage earner.
The IRS’ objective behind creating tax-deferred savings program was to offer equal benefits to all workers.
To prevent top earners from getting such unfair advantage, the IRS defined highly compensated employee to limit the contribution of the high earners based on the average contribution of the remaining employees. The difference between the annual contribution made by the top earners and average workers to the retirement plan should not exceed 2%.
For more information on retirement plans and highly compensated employee contribution, please refer to the IRS website.
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