The basics of the highly compensated employee rule
When the 401(k) plans were first written into law, there was concern that employees who made a lot of money each year would be able to hit the maximum limits much easier than a lower-paid employee.
To ensure a company’s 401(k) is not giving highly compensated employees an advantage, each company must analyze the participation rates of their employees. The basic steps are:
- Identify who in the company is an HCE.
- Calculate how much the HCEs contribute to the 401(k) plan.
- Calculate how much the non-HCEs contribute to the 401(k) plan.
- Compare HCE versus non-HCE.
- Take corrective actions if the HCE participation rate is greater than 2% of the non-HCE participation rates.
Of course, everything related to retirement plans and taxes is more complicated. See below for further details on each of these steps.
What is a highly compensated employee?
The IRS guidelines define a highly compensated employee as an individual who passes either an ownership test or a compensation test:
- Ownership test: Assesses if any employee owned more than 5% interest in the business at any time during the current or previous year
- Compensation test: Evaluates if any employee received compensation from the business of more than $135,000 (2022 threshold).
Calculating the Ownership Test
One of the methods for identifying highly compensated employees is to determine which employees own 5.01% or more of the interest in the business. How you calculate ownership depends on the type of business involved:
- Corporation: Examines each employee’s percentage of stock value or voting power
- Partnership: Assesses each employee’s percentage of capital or profit interest
- LLC/LLP: Looks at each employee’s percentage of membership interest
Please note that stock options count toward an employee’s ownership, even if they have not exercised their stock options yet.
Ownership attribution
When calculating employee ownership, a company must be aware of ownership attribution rules which dictate that it must combine an employee’s shares with their direct family’s shares (spouse, children, parent or grandparent).
For instance, if an employee owns 4% of shares and their spouse owns 3%, then the IRS considers the employee to have 7% ownership and will qualify as a highly compensated employee.
The IRS created these ownership attribution rules out of fear companies would use “creative ownership strategies” to reduce the number of HCEs and gain associated tax benefits.
Calculating the compensation test
One of the methods for identifying HCEs is to determine which employees are above the HCE compensation threshold. The IRS regularly adjusts this threshold to keep up with inflation, but as of 2022, the threshold stands at $130,000 in total compensation per year.
Total compensation includes the employee’s regular paycheck, as well as bonuses, commissions, salary deferrals and any overtime work.
Top pay group election
Some companies and industries may have a large percentage of their employees making above the $130,000 compensation threshold (e.g., a successful law firm or Silicon Valley tech firm). Companies such as this may have a very small number of non-HCEs, which can make it challenging for the business to keep both groups equitable from a statistical perspective.
To help alleviate this problem, a company can choose to take the top pay group election and designate only its top 20% of earners as HCE employees. This will push 80% of its employees into a non-HCE category, providing a statistically valid distribution to calculate the average participation of the two groups.
Example 401(k) non-discrimination test
The following is an example of a company that has identified its highly compensated employees and those who are not. It then calculated The total compensation (wages, bonus, etc.) for each group, divided by the total each group contributed to their 401(k).
|
Employee Type |
Total $ Comp |
Total $ 401(k) Contribution |
% of Comp Contributed |
|
HCE |
$5,000,000 |
$350,000 |
7% |
|
Non-HCE |
$1,000,000 |
$30,000 |
3% |
In the above example, the HCE group contributes 4% to its 401(k) compared to the non-HCE. The IRS requires a maximum 2% difference between the two groups. As a result, this company fails the 401(k) non-discrimination test and must take corrective action to its 401(k) plan.
How to fix a 401(k) with a failed non-discrimination test
Failing a non-discrimination test on a 401(k) plan is not a reason to cause instant panic, as the IRS gives companies some time to correct the problem. Companies struggling to manage their 401(k) plans within IRS requirements should probably seek professional advice from a tax consultant. However, the general approaches to fixing a 401(k) that fails the non-discrimination tests are:
- Refund some of the 401(k) contributions the HCE group made. If an HCE has contributed much more than their peers, then the company may need to return some of those contributions to the employee. In the example above showing the failed non-discrimination test, the company would need to refund $100,000 to the HCE group, so the contribution percentage drops to 5%.
- Have the company contribute additional funds on behalf of the non-HCE group. This is called a qualified nonelective employer contribution (QNEC). In the example above showing the failed non-discrimination test, the company would need to give the non-HCE group $20,000 to increase the contribution percentage to 5%.
If a company fails to correct its 401(k) issues, the IRS may levy a 10% penalty tax against the company. If the problems are egregious, the IRS may disqualify the entire 401(k) plan. This means it kicks all employees out of the plan, and the IRS sends large tax bills to both employees and the company.
FAQs about highly compensated employees
Do highly compensated employees have options if they wish to contribute more to a tax-beneficial retirement plan?
Yes, there are options for any employee looking to make annual 401(k) contributions that exceed the IRS or company annual limits. Once an employee maxes out a traditional 401(k), they should fund a Roth 401(k). The Roth plans do not have the same tax advantages as a traditional 401(k), but they also do not have limitations on contributions, salaries, or HCE rules.
Employees are also encouraged to fund plans their employer doesn’t sponsor, including traditional and Roth IRAs.
Can highly compensated employees above 50 years old contribute catchup funds?
After the age of 50 years old, the IRS allows employees to contribute extra funds to their 401(k) plan. For 2022, the standard limit of $20,500 increases to $27,000 for employees over 50 years old.
There is good news for HCE over 50 years old because the non-discrimination test calculation does not include the catchup funds. This means that HCE approaching retirement age should be able to increase their contributions without having those extra contributions refunded to them due to a failed HCE test.
