Highly Compensated Employee (HCE): Definition, How It Works, and Examples
Summary:
Highly Compensated Employees (HCE) are individuals who meet specific compensation and ownership thresholds as defined by the IRS. This classification affects their retirement contributions, especially in 401(k) plans, due to regulations aimed at ensuring fair tax advantages for all employees.
A Highly Compensated Employee (HCE) is a term defined by the Internal Revenue Service (IRS) that has significant implications for retirement planning, particularly regarding 401(k) contributions. As a company grows, differentiating between HCEs and non-HCEs becomes critical in ensuring fair tax advantages and retirement benefits for all employees. This article will dive into the IRS definition, the criteria for HCE classification, the impact on retirement contributions, and what it means for employees and employers.
What qualifies someone as a highly compensated employee?
An individual is classified as a highly compensated employee if they meet one of the two key criteria set by the IRS:
- The individual owns more than 5% of the company at any time during the current or preceding year.
- The individual earns above the IRS-specified threshold for compensation, which in 2024 is set at $155,000, and is in the company’s top 20% of earners.
Detailed criteria breakdown
Ownership interest: Even a fraction over 5% ownership, whether directly or indirectly (through family holdings), qualifies an employee as an HCE. This ownership rule includes interest held by spouses, children, or parents.
Compensation threshold: The compensation limit, adjusted yearly, applies to total earnings, including salary, bonuses, and deferred compensation.
IRS nondiscrimination test and its impact
To ensure fairness, the IRS mandates that 401(k) plans undergo annual nondiscrimination tests. These tests separate employees into highly compensated and non-highly compensated groups to evaluate the equity of benefits.
Nondiscrimination test overview
This test compares the average deferral rates of HCEs to those of non-HCEs. If HCE contributions exceed the IRS-mandated limits, the plan may fail the test.
Consequences of failure
Should a plan fail, HCEs may have excess contributions refunded, which then becomes taxable income.
How does HCE status impact retirement contributions?
For highly compensated employees, the IRS imposes limits on how much can be contributed to retirement plans, especially tax-deferred 401(k) plans.
Contribution limits
In 2024, HCEs can contribute up to $23,000 to their 401(k). However, if a company’s retirement plan fails the nondiscrimination test, the HCE’s contributions may be reduced.
Catch-up contributions
For those aged 50 or older, there is an additional catch-up contribution of $7,500 in 2024.
Examples of HCE scenarios
Example 1: Ownership-based HCE classification
Sarah works at a mid-sized tech company and owns 6% of the company’s stock. Even though her total compensation for the year is $120,000—below the IRS threshold for HCEs—Sarah is still classified as a highly compensated employee because she exceeds the 5% ownership limit. Her husband also owns 1% of the company’s stock, which means Sarah’s total interest in the company reaches 7%, further solidifying her HCE status.
Example 2: Compensation-based HCE classification
John is a senior executive at a large retail chain. His annual salary is $180,000, and he receives performance bonuses of $30,000, making his total compensation $210,000 for the year. While John doesn’t own any shares of the company, his compensation far exceeds the IRS limit of $155,000 for 2024. This, coupled with the fact that he’s among the top 20% of earners in his company, qualifies him as an HCE.
Example 3: Family ownership interest affecting HCE status
Emily is employed at her family-run business, where she personally owns 2% of the company. Her father owns 4% of the same company. Even though Emily’s earnings are only $100,000, her family’s combined ownership of 6% means she qualifies as a highly compensated employee under the IRS rules, which aggregate ownership for family members.
Strategies for highly compensated employees to maximize savings
Contributing to after-tax 401(k) plans
Some employers offer after-tax 401(k) contributions, which allow HCEs to contribute beyond the pre-tax limit set by the IRS. These contributions are not immediately tax-advantaged, but they grow tax-deferred, and upon withdrawal in retirement, only the earnings are subject to tax. This strategy is ideal for those looking to increase their savings without facing annual contribution limits imposed on pre-tax contributions.
Utilizing a mega backdoor Roth IRA
A “mega backdoor Roth IRA” allows HCEs to contribute after-tax dollars to their 401(k), then roll the funds over into a Roth IRA. This allows for substantial Roth contributions and tax-free growth, even if the HCE’s income is too high to contribute directly to a Roth IRA. For example, if an HCE contributes $10,000 in after-tax dollars to their 401(k), they can roll over that amount to a Roth IRA and benefit from tax-free growth on the investment.
Maximize health savings accounts (HSAs)
HCEs who are enrolled in high-deductible health plans (HDHPs) can also contribute to Health Savings Accounts (HSAs). These accounts allow for triple tax benefits—contributions are tax-deductible, the growth is tax-free, and qualified withdrawals for medical expenses are not taxed. For HCEs who have already maxed out their 401(k) and IRA contributions, an HSA can be a great way to continue building tax-advantaged savings.
Conclusion
Understanding the classification of a highly compensated employee (HCE) is essential for both employees and employers, especially when it comes to retirement planning and IRS compliance. While HCE status may come with certain contribution limits and tax implications, there are strategies available to maximize savings and maintain compliance. Always consult with your company’s benefits department to ensure you’re taking full advantage of the options available.
Frequently asked questions
What defines a highly compensated employee (HCE)?
A highly compensated employee is defined by the IRS as an individual who either owns more than 5% of the company at any point during the current or preceding year, or has earned above a certain compensation threshold ($155,000 in 2024) and is within the top 20% of earners in the company.
How does HCE status impact 401(k) contributions?
HCEs are subject to additional restrictions on how much they can contribute to their 401(k) plans, especially if their company fails the IRS nondiscrimination test. This can result in reduced contribution limits or the need for refunds of excess contributions.
What is the IRS nondiscrimination test?
The IRS nondiscrimination test is an annual evaluation of a company’s retirement plan to ensure that highly compensated employees are not receiving unfair advantages over non-HCEs. If a plan fails the test, it could result in contribution limits for HCEs or mandatory refunds.
Can highly compensated employees contribute to other retirement plans?
Yes, in addition to 401(k) contributions, highly compensated employees can contribute to other retirement accounts such as individual retirement accounts (IRAs) and health savings accounts (HSAs), which provide additional tax-advantaged savings options.
What are the tax implications of being classified as an HCE?
Being classified as an HCE may lead to additional tax implications, especially if excess contributions need to be refunded due to nondiscrimination test failures. These refunds are treated as taxable income in the year they are received.
How can HCEs maximize their retirement savings?
HCEs can maximize their savings by utilizing after-tax 401(k) contributions, engaging in a “mega backdoor Roth IRA” strategy, and contributing to health savings accounts (HSAs). These methods help HCEs bypass some of the contribution limits and gain tax advantages on their investments.
Key takeaways
- HCEs are defined by compensation levels and ownership interest.
- The IRS limits 401(k) contributions for HCEs to ensure fairness for all employees.
- Nondiscrimination tests ensure retirement plans don’t favor highly compensated employees.
- HCEs may face additional tax implications if their retirement plan fails IRS tests.
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