The Internal Revenue Service (IRS) provides a clear-cut definition of a Highly Compensated Employee (HCE). Under IRS guidelines, a person is deemed an HCE if they meet either or both of the following criteria:
- The individual owned more than 5% of the business at any time during the current or previous year. This holds regardless of the amount of compensation received.
- For the 2023 tax year, the individual received more than $150,000 in compensation and ranked within the company’s top 20% in pay. For 2024, this threshold increases to $155,000.
Key Insights for Highly Compensated Employees
- Retirement Contributions Limited: The 401(k) contributions of HCEs are subject to restrictions by IRS regulations.
- Ensuring Equity: The IRS mandates that benefits from pre-tax contributions should be equitable for all employees.
- Annual Nondiscrimination Test: All 401(k) plans must undergo a yearly nondiscrimination test to assess if employees are equally treated in tax advantages.
- Variable Contributions: The contribution limits for HCEs depend on the participation levels of non-HCE employees in the plan.
Demystifying the Concept of Highly Compensated Employees
Highly compensated employees face the challenge of restricted 401(k) contributions. To maintain fairness, IRS regulations ensure that pre-tax contribution benefits aren’t skewed towards a particular group. A key threshold is owning more than 5% of the company shares, which includes stakes held by close family members, excluding grandchildren or siblings.
Here’s a detailed example: if an employee owns exactly a 5% interest in the company, they’re not classified as an HCE. However, holding a 5.01% interest designates them as an HCE. Additionally, an employee who possesses a 3% stake and whose spouse owns a 2.2% stake will collectively exceed the 5% threshold, thus also being considered an HCE.
Initially, all employees could freely contribute to tax-deferred plans such as 401(k)s, with a maximum match of $22,500 for 2023, increasing to $23,000 in 2024. But high earners tend to contribute more, enjoying greater tax deductions. This led to the IRS imposing limits on contributions for these high earners to rectify the imbalance.
The Importance of the Nondiscrimination Test
Mandatory for all 401(k) plans, the nondiscrimination test segregates employees into highly compensated and non-highly compensated groups. The test scrutinizes HCE contributions to ensure balanced treatment of all employees. Contributions by HCEs mustn’t exceed 2% more than that of non-HCEs. Furthermore, the total contributions from HCEs cannot double the percentage of non-HCE contributions.
If compensation exceeds $155,000 in 2024 and they are within the top 20% compensated employees, the individual could be classified as an HCE. The compensation evaluation includes overtime, bonuses, commissions, and voluntary deferrals towards accounts like cafeteria plans and 401(k)s.
Additional Factors to Consider
When companies contribute towards defined-benefit or defined-contribution plans, the IRS regulations necessitate minimizing the benefit disparities between highly compensated and lower-paid employees. Failing to address imbalances could lead to the retirement plan losing its tax-qualified status, with all funds returned to the participants. This can have severe financial repercussions for the employer. Companies can address these imbalances by making extra contributions for non-HCEs or redistributing contributions from HCEs, the latter subject to tax upon withdrawal.
Contribution Limits for HCEs
For 2023, HCEs’ contributions cap at $22,500, with an additional $7,500 catch-up for those aged 50 and above. The 2024 limits raise the permissible contribution to $23,000, plus the $7,500 catch-up amount.
Diversifying Retirement Savings Beyond 401(k)
Open an IRA
Consider opening a traditional IRA alongside your 401(k) to gain additional pre-tax contribution opportunities. For 2023, you can contribute up to $6,500, which rises to $7,000 in 2024. Keep in mind, your deduction phases out at specific income levels if you or your spouse have workplace retirement plans.
Establish a Health Savings Account (HSA)
If you have a high-deductible health plan (HDHP), an HSA can be another efficient way to save. Contributions to your HSA grow tax-deferred and withdrawals are tax-free for qualified medical expenses.
Leverage a Brokerage Account
Although a brokerage account isn’t tax-advantaged, it allows for unlimited investments and withdrawals as needed. It’s a versatile option for building further savings, especially with tax-efficient securities like Treasury and municipal bonds.
Deferred Compensation Plan Considerations
Participate in a deferred compensation plan to defer a portion of your salary and associated taxes until post-retirement. Despite its similarities to a 401(k) in investment options, remember it’s an asset of the employer, not you. This implies that in case of company failure, access to your deferred compensation may be jeopardized.
Defining a Highly Compensated Employee (HCE)
According to IRS classification, an HCE is someone meeting either of the two primary conditions—owning more than 5% interest in the business any time during the specified years, or earning over $155,000 in 2024 within the top 20% of employee compensation.
Why Knowing Your HCE Status Matters
Understanding whether you are a highly compensated employee affects the IRS-mandated limits on your 401(k) contributions. Over-contributions might need to be refunded, contributing to your taxable income.
Why the IRS Regulates HCE Contributions
To ensure the exclusive tax advantages held by 401(k) plans are not disproportionately leveraged by highly-paid employees, the IRS enforces contribution limits for HCEs.
Conclusion
When uncertain about your HCE classification, consult your company’s benefits department. Confirm your 401(k) contribution limits and prepare for potential additional taxes if ahead-of-time contributions for the previous year need adjustment.
For instance, should you discover HCE status after contributing the maximum allowable amount, failing the nondiscrimination test means the company might refund the excess contributions, adding to your taxable income.
Related Terms: 401(k) Plan, tax-deferred retirement plans, nondiscrimination test, defined-benefit plan, defined-contribution plan, IRA, Health Savings Account (HSA).
References
- Internal Revenue Service. “Issue Snapshot - Identifying Highly Compensated Employees in an Initial or Short Plan Year”.
- Internal Revenue Service. “2024 Limitations Adjusted as Provided in Section 415(d), etc”. Page 2.
- National Archives, Code of Federal Regulations. “Title 26, Chapter I, Subchapter A, Part 1, Pension, Profit-Sharing, Stock Bonus Plans, etc., § 1.414(q)-1T Highly Compensated Employee (Temporary)”.
- Internal Revenue Service. “401(k) Limit Increases to $23,000 for 2024, IRA Limit Rises to $7,000”.
- Internal Revenue Service. “401(k) Plan Fix-It Guide - The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests”.
- Internal Revenue Service. “401(k) Plan Overview”.
- Internal Revenue Service. “Tax Consequences of Plan Disqualification”.
- Financial Industry Regulatory Authority (FINRA). “The ABCs of HSAs and FSAs”.
- Internal Revenue Service. “IRC 457(b) Deferred Compensation Plans”.
