Companies must identify highly compensated employees (HCEs) for their 401(k) to pass some required annual IRS tests
HCEs are determined by ownership OR compensation tests
The number of HCEs in a company should be taken into account when designing a retirement plan
What is a highly compensated employee (HCE)?
Determining who qualifies as a highly-compensated employee (HCE) is essential for performing certain annual nondiscrimination testing(NDT) required of all 401(k) plans.
NDT measures the participation levels of HCEs compared to non-highly compensated employees (NHCEs) in a company’s retirement plan. These tests ensure plans don’t unfairly benefit company owners (known as key employees) and HCEs over NHCEs. The IRS monitors plan participation this way in part because it offers meaningful tax benefits through 401(k) retirement savings plans.
For more on nondiscrimination testing—including the HCE threshold to pass ADP and ACP tests—read our guide on nondiscrimination testing. But for now, let’s dive into more details about HCEs.
Who is a highly-compensated employee (HCE)?
The IRS defines an HCE as an individual who meets either of the following criteria:
Ownership test: An employee is considered to be an HCE if he or she owns more than 5% of the company sponsoring the plan at any time during the current or previous plan year, regardless of compensation.
Compensation test: An employee is an HCE if he or she was actually paid more than a set dollar limit ($150,000 for 2023, $135,000 for 2022, $130,000 for 2020 and 2021) from the company in the preceding year. If stated in the document, employers may limit HCE’s based upon compensation to the top 20% of highly paid employees. This provision does not remove any owners from the HCE determination.
Ownership is determined at any time during the current or prior year. Therefore, even if an HCE reduces their ownership below the 5% threshold, they continue to be considered an HCEs through the end of the following plan year.
Highly-compensated employee vs. key employee
All key employees are highly-compensated employees; but not all HCEs are key employees. It’s important to understand the distinction. A key employee, according to the IRS, is anyone who qualifies as any of the following, any time during the plan year in question:
+5% owner: If an individual owns more than 5% of the company sponsoring the plan, regardless of compensation.
+1% owner: If an individual owns more than 1% of the company sponsoring the plan and also receives actual compensation of more than $150,000 for the year.
Officer: If an individual is an officer of the company sponsoring the plan and also receives actual compensation for the year of more than $215,000 for 2023 ($200,000 for 2022, $185,000 for 2020-2021).
For example, an officer of the company who earned less than $215,000 but more than $150,000 for 2023 would be an HCE but not a key employee.
Ownership: what counts?
For the purposes of identifying HCEs, “ownership” refers to any of the following.
In a corporation, the greater of following:
Value of all classes of stock held as a percentage of the total value
Voting power of all classes of stock held as a percentage of all stock with voting rights
In a partnership, the greater of:
Percentage of capital interest
Percentage of profit interest
In an LLC or LLP, membership interest as a percentage of total membership is considered ownership.
Ownership: Complicating factors
There are several circumstances that complicate the process of identifying a company’s HCEs.
Stock options: Any individual who has an option to acquire stock is treated by the IRS as owning that stock, which can qualify someone as an HCE even if they don’t actually own any stock in the company.
Ownership attribution: IRC Section 318 controls how ownership is attributed for HCE determination purposes. In summary, ownership is determined based upon a “one up, two down” rule (when viewed from the attributee). This means ownership is attributed to your grandparent, parent, child and spouse. Attributed ownership is added to any direct ownership that an employee has.
Related Companies: Ownership of a “related” company can also affect the number of HCEs. Companies related either through a controlled group or an affiliated service group relationship must take into account ownership of each entity. Someone may only own more than 5% of one related employer but is an HCE for the entire group for testing purposes.
ADP and ACP nondiscrimination 401(k) testing
Companies that offer traditional 401(k) plans must conduct actual deferral percentage (ADP) and actual contribution percentage (ACP) tests. The IRS measures retirement plan participation by looking at eligible employees’ average deferral contributions, and, if applicable, their matching contributions. Let’s review.
ADP test (actual deferral percentage)
This test compares the average percentage of the salary that participating HCEs defer to the average percentage that NHCEs defer. This percentage reveals how relatively engaged in the plan each employee type is at a glance.
There are two percentages you need to calculate:
Annual HCE contribution rate: Group HCEs together and calculate average annual employee deferral rate as a percentage of total compensation.
Annual NHCE contribution rate: Group non-HCEs together and calculate average annual employee deferral rate as a percentage of total compensation.
ACP test (actual compensation test)
This test only applies to companies that offer a matching contribution or after-tax contributions to employees’ 401(k) accounts. It uses the same calculations but includes these additional compensation categories.
What are the 401(k) rules for highly compensated employees?
401(k) contribution limits for highly compensated employees
In addition to making sure a company’s HCE contributions don’t exceed NHCE contributions through NDT, the IRS also imposes contribution limits.
The annual limit for elective deferral contributions to 401(k) plans is $22,500 in 2023 ($20,500 in 2022, $19,500 in 2021 and 2020), subject to cost-of-living adjustments. These numbers do not include catch-up contributions, which allow employees 50 and over to defer an additional $7,500 in 2023 ($6,500 in 2022, 2021, and 2020), bringing the total allowable deferral for employees 50 and over to $30,000 for 2023 ($27,000 in 2022, $26,000 in 2021 and 2020).
Annual limits for total contributions to all of an HCE’s 401(k) accounts maintained by one employer (and any related employer) may not exceed the lesser of 100% of your compensation or $66,000 for 2023 ($61,000 for 2022, $58,000 for 2021 and $57,000 for 2020). Including catch-up contributions increases the limits to $73,500 for 2023; $67,500 for 2022; $64,500 for 2021; and $63,500 for 2020.
The limits apply to the total of the following contributions including:
Elective deferrals and employee contributions
Employer matching contributions
Employer nonelective contributions
Allocations of forfeitures
Additionally, the amount of your compensation that can be taken into account when determining employer and employee contributions and performing NDT is limited to $330,000 for 2023 ($305,000 for 2022, and $290,000 in 2021). (For more information about related companies, see the section “Ownership: Complicating factors” above.)
HCEs and passing NDT: Now what?
Identifying HCEs is essential for performing annual testing required by the IRS. If your company is in the process of choosing or designing a retirement plan, knowing how many of your employees are likely to be designated HCEs or key employees is essential to selecting a plan that best suits both the company and your employees.
Similarly, when a company undergoes a reorganization, it’s important to keep track of how those changes will affect the HCE and key employee count. Doing so will allow the business to plan any necessary changes to the 401(k) ahead of the annual NDT, rather than playing catch-up after the fact.
By asking the right questions, Human Interest can help you determine if a safe harbor plan or imposing a lower contribution limit for HCEs and key employees would best serve your company and help all your employees save for retirement.
Article ByThe Human Interest Team
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