Definition

Highly Compensated Employee

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Who is a highly compensated employee (HCE)?

As per the Internal Revenue Service (IRS), a highly compensated employee is somebody who has done one of the following actions:

An employee who possesses more than 5% of a firm's stock irrespective of how much cash he or she received or earned during the year or the previous year.

Employees who got compensation over a specific amount as determined by the IRS. If the previous year is 2020 or 2021, for example, a worker got compensation from the firm of more than $130,000 and, if the company so chooses, was in the top 20% of workers when rated by compensation.

Highlights
  • A highly compensated employee has been described as someone who owns more than 5% of a firm's equity at any point throughout the year or the previous year.
  • The federal government compliance test analyses HCE contributions to assess whether all workers are treated equally under the firm's 401(k) plan.
  • The amount of money an HCE can put into their retirement plan is determined by the percentage of non-HCEs in the plan.

Frequently Asked Questions (FAQs)

What does it mean to be a "highly compensated employee"?

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The term "highly compensated employee" may appear to be a standard term for persons or executives, although an HCE is more than just anyone with a fancy title who earns a lot of money. The IRS has an exact definition of who is deemed an HCE, and there is no need to pay a massive amount of money to get that title.

The IRS retirement plans distinguish non-compensated employees and highly compensated employees. The goal is to make sure that all employees in a firm can benefit from their retirement plans in the same way.

Hence, the simplest way to determine "highly compensated employees" is to employ IRS criteria. Any person who fulfils such criteria is classified as a highly compensated employee. One of the criteria is ownership of more than 5% of a corporation's shares, and the other is personnel who get compensation over a specific amount.

On the other hand, an employee can only be considered an HCE if he or she works for the firm. If a non-employee owns 5.01% or more of the company but is not an employee, he or she cannot become HCE.

The compensation has been defined to incorporate the regular recurring payments from the corporations and overtime payments, commissions, bonuses, and other benefits.

Furthermore, the 5% interest rate is calculated depending on the price of a company's stock. Therefore, it encompasses the interests of employees, their children, wife, and grandchildren who work for the same company.

For instance, a person buys 2.5% of a company's stock, his wife has 1.5%, and their child holds 1.2% of the same company. Their overall possession amounts to 5.2%, which is higher than the 5% limit and qualifies a highly compensated employee.

What are the 401(k) restrictions for highly compensated employees?

The 401(k) plan is a tax-deferred defined-contribution pension plan designed by the IRS to offer equitable benefits to all workers in a firm. Workers can contribute as much as they like to their plans, although they are limited to $19,500 per year in 2020 and 2021. Businesses may match the contributions up to a specific proportion, and workers choose to pick their investments and take risks.

Moreover, highly compensated employees can contribute more and gain more from the tax deduction, notably if they are in a higher tax bracket. Therefore, to make sure that workers have an equal opportunity to benefit from their retirement plans, the IRS imposed further restrictions on the number of contributions that highly compensated employees can make.

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As per the IRS, every year, all 401(k) plans should pass a non-discrimination test. Non-highly compensated employees (NHCE) and highly compensated employees (HCE) are divided into two groups by the test. 

The IRS's non-discrimination provisions were put in place to ensure that employee retirement plans do not bias in support of highly compensated workers. The IRS was able to regulate deferred plans by defining highly compensated workers, ensuring that firms were not only putting up retirement plans to favour their executives.

In addition, the plan would fail the non-discrimination test if the average contribution-to-salary ratio of highly compensated employees is more than 2% higher than the ratio of other employees.

For instance, non-highly compensated employees of a firm contributed an average of 8% of their wages per year. On the other hand, highly compensated employees may contribute no more than 10% of their wages in that year. If this isn't the case, the plan won't pass the test, and the contributions should be returned to the workers in full.

Other Considerations 

Highly compensated employees are only allowed to make a restricted amount of 401(k) contributions. Even so, there are alternative ways for individuals to boost their retirement assets. The alternative approaches are mentioned below. 

Making up post-tax contributions to conventional Individual Retirement Accounts (IRAs) or opening a backdoor Roth IRA is one strategy. Roth IRA contributions are not tax-deductible, though withdrawals are free from tax.

Another option would be to have a Health Savings Account (HSA). HSAs could be funded using pre-tax income, and withdrawals are tax-free as far as they're utilised to pay for eligible medical costs.

Even though HSAs give attractive tax benefits, the withdrawal limits are incredibly tight. If a person tries to withdraw non-qualified expenses before reaching the age of 65, it will not only be taxable, but a person will also be subject to a 20% penalty. Another disadvantage of HSAs is transaction costs and monthly maintenance fees.

What impact do HCE regulations have on you?

The rules for highly compensated employees might affect you in various ways, and they were put in place to safeguard individuals who do not belong to this small subset of people.

At the time of its introduction, retirement plans permitted anybody to contribute a certain proportion of their earnings regardless of income. Consequently, individuals who made so much money got a lot of tax advantages, but employees who made less money didn't get a lot of tax cuts, which was proven to be discriminatory.

The IRS designed the highly compensated employee rules and regulations to ensure that all employees are treated fairly and that tax breaks, and retirement savings are available.