As a business owner or HR professional managing a 401(k) plan, you've likely encountered the term "Highly Compensated Employee" (HCE). It might sound like a badge of honor, but in the world of retirement plans, it comes with specific rules and regulations that are crucial for maintaining your plan's tax-qualified status.
Ready to dive into the intricacies of HCE determination for your 401(k) plan? Let's get started!
Understanding the Importance of HCEs in 401(k) Plans
The IRS established rules around HCEs to prevent 401(k) plans from disproportionately benefiting highly paid individuals at the expense of rank-and-file employees. To ensure fairness, the IRS mandates annual nondiscrimination testing. If your plan fails these tests, it can lead to corrective actions, such as requiring HCEs to withdraw excess contributions, or even risking the plan's tax-favored status. Therefore, accurate HCE identification is the cornerstone of 401(k) compliance.
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| How To Determine Highly Compensated Employees For 401k |
Step 1: Grasping the HCE Definition - The Two Key Tests
The IRS provides two primary tests to determine who is a Highly Compensated Employee for a given plan year. An employee is an HCE if they satisfy either of these tests.
Sub-heading 1.1: The Compensation Test
This test focuses on an employee's earnings. For the 2025 plan year (which typically looks at compensation from the 2024 calendar year), an employee is generally considered an HCE if they received more than $160,000 in compensation from your business during the prior plan year (the "lookback year").
Important Note: This dollar amount is adjusted annually by the IRS for inflation. Always refer to the most current IRS guidance for the precise figure.
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What counts as "compensation"?
For HCE determination, "compensation" is broadly defined and includes:
Regular salary and wages
Bonuses
Commissions
Overtime payments
Elective deferrals to a 401(k) plan
Contributions to cafeteria plans
Sub-heading 1.2: The Ownership Test
This test considers an employee's ownership stake in the business. An employee is an HCE if they were a 5% owner of the business at any time during the current plan year (the "determination year") OR during the immediately preceding 12-month period (the "lookback year"), regardless of their compensation amount.
What does "5% owner" mean?
This isn't just about direct stock ownership. The IRS has "family attribution" rules that can extend ownership. If an employee is the spouse, child, parent, or grandparent of someone who owns more than 5% of the company, that employee is also considered a 5% owner for HCE purposes, even if they don't directly own any shares themselves. This is a common pitfall, so be meticulous when reviewing family relationships of owners.
Step 2: Applying the "Lookback Year" Principle
A critical aspect of HCE determination is the "lookback year" concept. For a given plan year, you generally identify HCEs based on data from the preceding 12-month period.
Example: For your 401(k) plan year starting January 1, 2025, you would look at compensation earned and ownership held during the 2024 calendar year to identify HCEs.
There are exceptions for initial plan years or short plan years, but for most established plans, the prior calendar year is the key.
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Step 3: Considering the "Top-Paid Group Election" (Optional)
For the compensation test only, employers have an optional election: the "top-paid group election." If your company makes this election, an employee is considered an HCE due to compensation only if they received compensation above the IRS threshold (e.g., $160,000 for 2025 based on 2024 earnings) AND they were among the top 20% of employees when ranked by compensation for that lookback year.
Why would an employer make this election? It can potentially reduce the number of HCEs, making it easier to pass nondiscrimination tests. However, it adds a layer of complexity to the calculation.
Sub-heading 3.1: How to Calculate the Top 20%
If you choose the top-paid group election, here's how to determine the top 20%:
Identify all employees: Include all employees of the employer (and any related employers, if applicable).
Exclude certain employees: The IRS allows you to exclude certain categories of employees from this calculation, such as:
Employees who haven't completed six months of service.
Employees who normally work fewer than 17½ hours per week.
Employees who normally work fewer than six months during any year.
Employees who are under age 21.
Employees who are covered by a collective bargaining agreement, if at least 90% of employees are covered by such agreements and the plan covers only non-union employees.
Nonresident aliens with no U.S.-source income.
Rank the remaining employees by compensation: List all eligible employees from highest to lowest compensation for the lookback year.
Calculate the top 20%: Multiply the total number of eligible employees by 0.20. The employees falling into this top percentage, who also meet the compensation threshold, are considered HCEs.
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Step 4: Compiling Your List of HCEs
Once you've applied the ownership test and, if applicable, the compensation test (with or without the top-paid group election), you'll compile a final list of Highly Compensated Employees for the upcoming plan year. This list is crucial for your 401(k) plan's annual nondiscrimination testing.
Step 5: Understanding the Implications: Nondiscrimination Testing
The primary reason for identifying HCEs is to ensure your 401(k) plan passes various nondiscrimination tests, which compare the participation and contribution rates of HCEs to Non-Highly Compensated Employees (NHCEs).
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Sub-heading 5.1: Actual Deferral Percentage (ADP) Test
This test compares the average salary deferral percentage (employee contributions) of HCEs to that of NHCEs. Generally, the HCE average cannot exceed the NHCE average by more than 2 percentage points or 125% of the NHCE average, whichever is greater.
Sub-heading 5.2: Actual Contribution Percentage (ACP) Test
Similar to the ADP test, the ACP test applies to employer matching contributions and after-tax employee contributions. It ensures that these contributions do not disproportionately favor HCEs.
Sub-heading 5.3: Top-Heavy Test
While distinct from HCE determination, the "top-heavy" test often overlaps. A plan is top-heavy if more than 60% of the plan's assets are held by "key employees." Key employees include 5% owners, 1% owners with compensation over a certain limit (e.g., $150,000), and officers with compensation over a separate limit (e.g., $230,000 for 2025). If a plan is top-heavy, it generally requires a minimum contribution for non-key employees. Many HCEs are also key employees, but not all.
Step 6: Addressing Failed Tests: Correction Methods
If your 401(k) plan fails any of the nondiscrimination tests, you'll need to take corrective action to maintain its tax-qualified status. Common correction methods include:
Distributing excess contributions to HCEs: This is the most common method. HCEs receive a taxable refund of their excess deferrals or contributions, bringing their average percentages down to a passing level.
Making Qualified Nonelective Contributions (QNECs) or Qualified Matching Contributions (QMACs) to NHCEs: The employer makes additional contributions to the accounts of NHCEs to raise their average deferral/contribution percentages, thereby allowing the HCEs' contributions to remain in the plan. These contributions must be 100% vested.
Adopting a Safe Harbor 401(k) Plan: A "safe harbor" design can automatically satisfy certain nondiscrimination tests (ADP and ACP tests) by committing to specific employer contributions (e.g., a matching contribution or a non-elective contribution) that are 100% vested. This can be a great way to simplify compliance, though it involves a guaranteed employer contribution.
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Step 7: Ongoing Vigilance and Professional Assistance
Determining HCEs and ensuring 401(k) plan compliance is an annual process. The compensation thresholds change, employee rosters evolve, and ownership structures can shift.
Maintain accurate records: Keep meticulous records of employee compensation, hire dates, ownership interests, and family relationships.
Review annually: Conduct a thorough review of your HCE list at the end of each plan year to prepare for the following year's testing.
Consider professional help: Many employers outsource 401(k) administration and compliance testing to third-party administrators (TPAs) or retirement plan advisors. These professionals have the expertise to navigate the complex IRS rules and ensure your plan remains compliant. It can save you a lot of headaches and potential penalties!
10 Related FAQ Questions
How to track HCE compensation accurately?
Ensure your payroll system can segregate and report all forms of compensation that are counted for HCE determination, including salary, bonuses, and elective deferrals. Regular reconciliation with HR records is key.
How to handle an employee who becomes an HCE mid-year?
HCE status for a given plan year is determined based on the prior year's compensation and current/prior year's ownership. So, an employee typically becomes an HCE at the start of the plan year, based on their prior year's status. If an employee's status changes significantly, it will impact their HCE status for the next plan year.
How to deal with family attribution rules for ownership?
When determining 5% ownership, remember to attribute ownership interests of a spouse, child, parent, or grandparent to the employee. This means meticulously identifying family relationships within the ownership structure.
How to know the current HCE compensation limit?
The IRS typically announces the updated compensation limits for the upcoming year in the fall of the preceding year. Always consult official IRS publications or a reliable retirement plan resource for the most current figures. For 2025, it is $160,000 (based on 2024 earnings).
How to correct a failed ADP/ACP test?
The most common methods are distributing "excess contributions" (refunds) to HCEs or making "qualified nonelective contributions" (QNECs) to NHCEs to boost their average contribution rates.
How to avoid nondiscrimination testing failures altogether?
Consider converting your 401(k) plan to a "Safe Harbor" design. This plan type involves specific, mandatory employer contributions that are 100% vested, which can exempt your plan from the ADP and ACP tests.
How to communicate HCE status to employees?
While not explicitly required, it's generally good practice to inform HCEs if their contributions might be restricted due to nondiscrimination testing. Open communication can help manage expectations.
How to determine if an officer's compensation makes them a Key Employee for top-heavy testing?
For the 2025 plan year, an officer is considered a "Key Employee" if their compensation exceeded $230,000 in the prior year. This limit is also subject to annual IRS adjustments.
How to manage 401(k) contributions for HCEs who are also Key Employees?
HCE status impacts nondiscrimination testing, while Key Employee status impacts top-heavy testing. It's possible for an individual to be both. Ensure your plan design and contributions comply with both sets of rules.
How to find professional help for HCE determination and 401(k) compliance?
Look for Third-Party Administrators (TPAs) specializing in retirement plan administration, ERISA attorneys, or financial advisors with expertise in 401(k) plan compliance. They can provide essential guidance and services.
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