Highly Compensated Employee (HCE) Definition and Compensation Threshold

What Is a Highly Compensated Employee (HCE)?

The Internal Revenue Service (IRS) defines a highly compensated employee (HCE) as one who meets either or both of the following standards:

• Owned more than 5% of the business at any time during the year or the preceding year, regardless of the amount of compensation received.
• Received more than $150,000 in compensation in the 2023 tax year and was in the company's top 20% in pay. In the 2024 tax year, the amount increases to $155,000.

Understanding Highly Compensated Employees

The disadvantage of being classified as a highly compensated employee is that your 401(k) plan contributions are limited. The IRS wants to make sure that the taxable income-lowering advantage offered by pre-tax contributions doesn't benefit one group of employees more than others.

The 5% threshold for HCEs mentioned above is based on voting power or the value of company shares. The interest owned by an individual also includes the interest held by relatives such as spouses, parents, children, and grandparents (but not grandchildren or siblings).

For example, an employee with exactly 5% ownership in the company is not considered a highly compensated employee. One with a 5.01% interest in the company has the HCE status. An employee with 3% holdings in the company will be considered an HCE if the person's spouse owns 2.2% interest in the same company (making the employee's total interest 5.2%).

Tax-deferred retirement plans such as 401(k) plans were implemented by the IRS to offer equal benefits to all workers. Initially, all employees could contribute as much as they wanted to, with the total contribution matched by the employer up to $22,500 for 2023. The figures increase to $23,000 in 2024.

That meant high earners could contribute much more than other employees. Thus, they would benefit to a greater degree from the tax deductions that lower taxable income.

To correct this disparity, the IRS set limits on the dollar amount of contributions that can be made by high earners.

Nondiscrimination Test

The IRS requires that all 401(k) plans perform a nondiscrimination test every year. The test separates employees into two groups: non-highly compensated and highly compensated employees. 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 nondiscrimination stipulations are designed to make sure that the tax advantages of employee retirement plans do not disproportionately favor highly compensated employees.

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 employee contributions.

Other Considerations

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 an employer fails to correct a discrepancy, the plan is liable to lose its tax-qualified status. All contributions would have to be returned 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 its non-highly compensated employees. Or, the firm can make distributions from its retirement plans to the highly compensated employees, who would then have to pay taxes on the withdrawals.

401(k) Contribution Limits for Highly Compensated Employees

For 2023, highly compensated employees can contribute up to $22,500 to a 401(k) plan. If they’re age 50 or older, they can contribute an additional $7,500 catch-up amount.

In 2024, they can contribute up to $23,000, plus $7,500 as a catch-up contribution.

Other Retirement Savings Options for Highly Compensated Employees

Open an IRA

In addition to your 401(k), open a traditional IRA to add a pre-tax contribution of up to $6,500 in 2023. In 2024, the number rises to $7,000 and the $1,000 catch-up amount remains unchanged.

The deduction for contributions is reduced and ultimately phases out if you or your spouse have a workplace retirement plan and your adjusted gross income is above a certain amount. However, you'll still be able to build your tax-deferred retirement savings.

Open a Health Savings Account (HSA)

If you have a high-deductible health plan (HDHP), consider opening a health savings account (HSA). While helping you save for uncovered healthcare expenses, they also provide tax benefits.

You contribute pre-tax dollars to an HSA and your earnings grow tax-deferred. You can invest in a variety of securities including stocks, bonds, and mutual funds. Moreover, the money you withdraw from it is tax-free as long as it's used to pay for qualified medical expenses.

Open a Brokerage Account

It may not be a tax-advantaged account, but it can help you build more savings. You can invest in all kinds of securities, including those with their own tax advantages such as Treasury bonds and municipal bonds. You can invest as much as you wish and take money out at any time.

Participate in a Deferred Compensation Plan

This type of plan allows you to defer a certain percentage of your salary and the taxes you'd pay on it, typically until after you retire. There are no limits to the amount you can defer and the investment options are similar to those available to a 401(k). You'll owe taxes on the plan payouts after you retire.

Bear in mind that a deferred compensation plan is an asset of the company. You don't own it, as you do your 401(k). If the company fails, you won't have access to the compensation you deferred.

The Bottom Line

When in doubt, ask your company's benefits department whether or not you're a highly compensated employee. Double-check on the amount you can contribute to your 401(k). You also want to be prepared to pay additional taxes on what you may have contributed in the previous year.

For example, if it turns out that you are an HCE and you contributed the maximum, there could be consequences. If your company fails the nondiscrimination test, it will probably refund you the excess contributions you made. This will be considered taxable income.