Highly Compensated Employee (HCE)

A Highly Compensated Employee (HCE) is a classification used by the IRS to identify employees who earn high salaries or hold significant ownership stakes in a company. This designation plays a crucial role in ensuring employer-sponsored retirement plans, such as 401(k)s, do not disproportionately benefit top earners at the expense of other employees.

IRS Criteria for Defining a Highly Compensated Employee

To be classified as an HCE, an employee must meet one or both of the following IRS criteria:

• Ownership Test: Owned more than 5% of the business at any time during the current or previous year, regardless of compensation.
• Compensation Test: Earned more than $135,000 in the previous year (the threshold is updated annually for inflation; check the current IRS guidelines).

Additionally, employers may elect to consider the top 20% of employees by compensation as HCEs, though this is less common.

Why Does the IRS Define HCEs?

The IRS uses the HCE designation primarily to enforce nondiscrimination rules in qualified retirement plans. These rules prevent plans from favoring highly paid employees or owners over rank-and-file workers. Through nondiscrimination testing, plans compare contribution and benefit levels between HCEs and non-HCEs to ensure equitable treatment.

If a plan fails these tests, employers may need to refund excess contributions to HCEs or limit their future contributions, which can affect retirement savings strategies.

Impact of HCE Status on Employees and Employers

• Employees: Being classified as an HCE can limit how much you can contribute or receive in employer retirement plan benefits due to nondiscrimination testing requirements.
• Employers: Must administer testing to ensure compliance or risk plan disqualification or penalties. Plan design considerations often address balancing benefits for HCEs and non-HCEs.

Practical Example

If you earned $140,000 last year, you meet the compensation test and are considered an HCE. Alternatively, if you own 6% of the company—even with a $90,000 salary—you qualify as an HCE by ownership.

Tips for Highly Compensated Employees

• Monitor your compensation and ownership status yearly.
• Coordinate with your HR department to understand your retirement plan’s nondiscrimination testing.
• Diversify retirement savings by using accounts like Individual Retirement Accounts (IRAs) to supplement employer plans.

Common Misconceptions

• Only owners are HCEs: High salary alone qualifies.
• Only CEOs are HCEs: Many employees can be HCEs based on earnings.
• HCE status means higher taxes: It only affects retirement plan contributions and testing, not individual tax rates.

Frequently Asked Questions

Q: How often is the HCE compensation threshold updated?

• Annually, adjusted for inflation by the IRS.

Q: Can employers redefine who counts as an HCE?

• Employers can elect the top 20% highest-paid employees method, but must comply with IRS rules.

Q: What happens if a retirement plan fails the HCE nondiscrimination test?

• Employers may refund excess contributions to HCEs or reduce future contributions.

Summary Table: HCE Criteria

For a deeper understanding of retirement plans affected by HCE rules, explore our Retirement Plan glossary entry.

Authoritative Sources

• IRS on Highly Compensated Employees: https://www.irs.gov/retirement-plans/highly-compensated-employees
• IRS 401(k) Nondiscrimination Testing: https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-sponsors-nondiscrimination-tests
• Investopedia: https://www.investopedia.com/terms/h/highly-compensated-employee.asp