You're ready to dive into the often-complex world of 401(k) compliance, and specifically, how to identify Highly Compensated Employees (HCEs). This is a critical step for any employer sponsoring a 401(k) plan, as it directly impacts your ability to pass crucial nondiscrimination tests and avoid penalties. So, let's get started on this journey to understanding HCE determination!
How to Determine Highly Compensated Employees (HCEs) for Your 401(k) Plan: A Step-by-Step Guide
The Internal Revenue Service (IRS) has specific rules to ensure that 401(k) plans don't disproportionately benefit high-earning individuals over the rest of the workforce. This is where the concept of a Highly Compensated Employee (HCE) comes in. Identifying HCEs is the first and most important step in performing the annual nondiscrimination tests (like the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests) that every traditional 401(k) plan must pass.
Let's break down the process.
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| How To Determine Hce For 401k |
Step 1: Understand the "Look-Back Year" Principle
Before we delve into the specific tests, it's vital to grasp the concept of the "look-back year." For most 401(k) plans, the determination of HCEs for the current plan year is based on data from the immediately preceding 12-month period.
For example, if your 401(k) plan operates on a calendar year (January 1st to December 31st), to determine HCEs for the 2025 plan year, you will look at data from the 2024 calendar year.
This is a common point of confusion, so always remember: you're generally looking backward to identify HCEs for the present.
Step 2: Apply the Two Primary HCE Tests
An employee is classified as an HCE if they meet either of the following two criteria during the look-back year (or in some cases, the current year for ownership):
Sub-heading 2.1: The Ownership Test (5% Owner)
This test is straightforward. An employee is an HCE if they owned more than 5% of the interest in the business that sponsors the 401(k) plan at any time during:
QuickTip: Re-reading helps retention.
The current plan year, OR
The preceding plan year (the "look-back year").
Important Note on Ownership Attribution: This is where it can get tricky! The IRS has "family attribution rules" that can significantly impact who is considered a 5% owner. Ownership is attributed to an employee from their spouse, children (including legally adopted children, regardless of age), parents, and grandparents. This means if an employee directly owns 4% of the company, but their spouse owns 2%, the employee is treated as owning 6% and would be an HCE.
For corporations, "interest in the business" refers to either the value of all classes of stock or the total voting power of all stock with voting rights. For partnerships or LLCs/LLPs, it refers to the percentage of capital or profit interest.
Sub-heading 2.2: The Compensation Test
This test focuses on an employee's earnings. An employee is an HCE if they received compensation from the business above a certain dollar limit in the preceding year (the "look-back year").
The IRS adjusts this dollar limit annually for inflation. Here are some recent limits for reference (always verify the current year's limit with the IRS or your plan administrator):
2025 Plan Year (based on 2024 compensation): $160,000
2024 Plan Year (based on 2023 compensation): $155,000
2023 Plan Year (based on 2022 compensation): $150,000
What counts as "compensation"? For HCE determination, compensation generally includes an employee's:
Regular wages and salaries
Bonuses
Commissions
Overtime payments
Elective deferrals to a 401(k) plan
Contributions to a cafeteria plan
The "Top-Paid Group Election" (Optional Rule): This is a crucial employer option that can significantly reduce the number of HCEs under the compensation test. If elected in your plan document, an employee who meets the compensation threshold must also be in the top 20% of employees when ranked by compensation during the look-back year to be considered an HCE.
This election can be incredibly helpful for companies with a large number of high earners, as it can shift some employees who would otherwise be HCEs into the Non-Highly Compensated Employee (NHCE) category, making nondiscrimination testing easier to pass. However, this election must be formally adopted in your plan document.
Step 3: Compile Your Employee Data for the Look-Back Year
Now that you understand the criteria, it's time for data collection. For the relevant look-back year, you'll need the following information for every employee who was employed by your company at any point during that year:
Employee Name
Total Compensation (as defined for HCE purposes, including all wages, bonuses, and pre-tax deferrals).
Ownership Percentage (direct and indirect, considering family attribution rules).
Step 4: Systematically Apply the HCE Tests
With your data in hand, go through each employee and apply the tests:
QuickTip: Reread for hidden meaning.
Start with the Ownership Test: For each employee, determine if they (or anyone whose ownership is attributed to them) owned more than 5% of the business at any point in the look-back year or current year. If yes, mark them as an HCE. They are an HCE regardless of their compensation.
Move to the Compensation Test: For all remaining employees (those who did not meet the 5% ownership test), check their compensation for the look-back year against the IRS's HCE compensation limit for that year.
If their compensation exceeds the limit, and you have not made the Top-Paid Group Election, mark them as an HCE.
If their compensation exceeds the limit, and you have made the Top-Paid Group Election, you'll then need to rank all employees by compensation and identify the top 20%. Only those in the top 20% who also exceed the compensation limit will be HCEs.
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Step 5: Finalize Your HCE List
After applying both tests to all relevant employees, you will have a definitive list of your Highly Compensated Employees for the current plan year. This list is crucial for your 401(k) plan's annual nondiscrimination testing.
Step 6: Prepare for Nondiscrimination Testing
Once you have identified your HCEs, the next step is to perform the required nondiscrimination tests. The two most common are:
Actual Deferral Percentage (ADP) Test: Compares the average deferral percentage of HCEs to that of Non-Highly Compensated Employees (NHCEs). This test applies to pre-tax and Roth 401(k) deferrals.
Actual Contribution Percentage (ACP) Test: Compares the average contribution percentage of HCEs to that of NHCEs, specifically for employer matching contributions and employee after-tax contributions.
The IRS limits how much higher the HCEs' average contribution percentages can be compared to the NHCEs' percentages. If your plan fails these tests, corrective actions will be necessary, which often involve refunding excess contributions to HCEs or making Qualified Nonelective Contributions (QNECs) or Qualified Matching Contributions (QMACs) to NHCEs.
Step 7: Document Everything!
Maintain thorough and accurate records of your HCE determination process. This includes:
The data used (compensation figures, ownership percentages).
The calculations performed.
The final HCE list.
Any elections made (e.g., Top-Paid Group Election).
Good record-keeping is vital for demonstrating compliance to the IRS if your plan is ever audited.
Related FAQ Questions
Here are 10 frequently asked questions about HCE determination, with quick answers:
Tip: Don’t just glance — focus.
How to: Understand the HCE compensation limit for the current year?
The HCE compensation limit is adjusted annually by the IRS. For the 2025 plan year, based on compensation from the 2024 calendar year, the limit is $160,000. Always refer to the latest IRS guidance for the most up-to-date figures.
How to: Determine if a new hire is an HCE?
A newly hired employee typically won't be an HCE based on the compensation test in their first year of employment, as they won't have compensation from the preceding look-back year. However, they could be an HCE if they meet the 5% ownership test at any point during the current or preceding year.
How to: Handle family members of owners for HCE determination?
Due to family attribution rules, the ownership of a spouse, child (regardless of age), parent, or grandparent is attributed to an employee. If, after attribution, an employee is deemed to own more than 5% of the business, they are an HCE, even if their direct ownership is less than 5%.
How to: Apply the "Top-Paid Group Election"?
If elected in your plan document, an employee only qualifies as an HCE under the compensation test if they are both above the compensation limit and are in the top 20% of all employees when ranked by compensation for the look-back year. This election can reduce the number of HCEs.
How to: Differentiate between an HCE and a "Key Employee"?
While both are high-level classifications, HCEs are determined for nondiscrimination testing (ADP/ACP), while "Key Employees" are determined for "top-heavy" plan testing. The criteria for each are distinct, though there can be overlap. Key employees include officers making over a certain amount, 5% owners, and 1% owners making over $150,000 (amounts adjusted annually).
QuickTip: Skip distractions — focus on the words.
How to: Correctly identify "compensation" for HCE purposes?
Compensation for HCE determination generally includes all taxable wages, salaries, bonuses, commissions, and any elective deferrals (like 401(k) and cafeteria plan contributions). It's typically the amount reported in Box 1 of a W-2, plus pre-tax deferrals.
How to: Handle employees who leave the company mid-year?
An employee's HCE status is determined based on their compensation and ownership in the look-back year. If they met the criteria in the look-back year, they are an HCE for the current testing year, even if they terminated employment before the end of the current year.
How to: Get help with HCE determination and nondiscrimination testing?
Many employers work with a Third-Party Administrator (TPA) or a retirement plan consultant. These professionals specialize in 401(k) compliance and can accurately perform HCE determinations and nondiscrimination testing.
How to: Know if your 401(k) plan is "top-heavy"?
A plan is "top-heavy" if the aggregate account balances of "Key Employees" exceed 60% of the total plan assets. This test uses different criteria than HCE determination, but 5% owners are considered Key Employees. If a plan is top-heavy, a minimum contribution may be required for non-key employees.
How to: Avoid failing nondiscrimination tests due to HCE contributions?
Strategies to help pass include: encouraging higher NHCE participation (e.g., through auto-enrollment, plan design, or increased education), offering safe harbor 401(k) plans (which are generally exempt from ADP/ACP testing), or in some cases, capping HCE contributions.
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