Key employee

What is a key employee

In the world of 401(k) plans, a key employee is a specific category of worker defined by the Internal Revenue Service (IRS). This classification is different from, but sometimes confused with, highly compensated employees (HCEs). Key employees are typically high-level executives, owners, or top earners within a company. The IRS uses this designation to ensure that 401(k) plans are fair and beneficial for all employees, not just those in leadership positions.

It's important to note that while some key employees may also be highly compensated employees, not all HCEs are considered key employees. This distinction plays a crucial role in various aspects of 401(k) plan administration and testing. The goal is to balance the benefits provided to key employees with the need to maintain a fair, compliant plan for all participants.

Importance in 401(k) plan administration

Identifying key employees is crucial for 401(k) plan administration for several reasons:

• Compliance: Proper classification ensures the plan adheres to IRS regulations.

• Fairness: It helps maintain equitable benefits distribution among all employees.

• Financial planning: It affects contribution limits and plan design strategies.

• Risk management: Misclassification can lead to penalties and plan disqualification.

Criteria for key employee classification

The IRS defines key employees based on the following criteria:

1. Ownership threshold: Any employee who owns more than 5% of the business (directly or indirectly) is considered a key employee.

2. Ownership and compensation: An employee who owns more than 1% of the business and receives annual compensation exceeding $150,000 is classified as a key employee.

3. Officer compensation: Officers of the company receiving annual compensation over $215,000 (as of 2024, adjusted annually for inflation) are key employees.

Difference between key employees and highly compensated employees

While often confused, key employees and highly compensated employees are distinct classifications in 401(k) plans, each serving different purposes:

Key employees:

• Used primarily for top-heavy plan testing

• Include 5% owners, 1% owners earning over $150,000, and officers earning above the threshold

• Thresholds are generally higher than for HCEs

Highly compensated employees:

• Used for nondiscrimination testing (ADP/ACP and coverage tests)

• Include 5% owners and employees earning above a certain threshold (e.g., $135,000 in 2024)

• More employees typically fall into this category than Key Employees

The main difference lies in their application: Key Employee status primarily affects top-heavy plan rules, while HCE status is crucial for nondiscrimination testing. A key employee is often an HCE, but an HCE isn't necessarily a key employee.

Top-heavy rules and key employees

Top-heavy rules are intricately linked to the concept of key employees in 401(k) plans. A plan is considered top-heavy when more than 60% of the account balances belong to key employees. This status triggers several important requirements. 

• Top-heavy plans must provide minimum contributions, typically 3% of compensation, to non-key employees. 

• For defined contribution plans, such as 401(k)s, these plans may be subject to accelerated vesting schedules, ensuring that non-key employees have faster access to employer contributions. Note that vesting rules for defined benefit plans differ.

• The top-heavy status of a plan must be determined annually, adding an ongoing compliance responsibility for plan administrators. 

These rules are designed to prevent plans from disproportionately benefiting key employees and to ensure that all employees, regardless of their position or compensation level, receive meaningful benefits from the company's retirement plan.

Learn more 401(k) Top-heavy Testing