Are You an HCE and Why Would You Care?

Who qualifies as a Highly Compensated Employee (HCE)?

According to IRS guidelines, an HCE typically falls into one of three categories: 1) anyone who owns more than 5% of the company, 2) family members of someone who owns more than 5% (including spouse, parents, children, or grandparents), or 3) employees who earned more than $155,000 in the previous calendar year (2024 limit; this amount is subject to annual IRS cost-of-living adjustments). Understanding who is considered an HCE is important for meeting certain retirement plan compliance requirements.

The IRS requires 401(k) plans to undergo several compliance—or “nondiscrimination”—tests each year. These tests ensure that all employees, regardless of their compensation level, are treated fairly by the plan. The main goal is to prevent highly compensated employees (HCEs) from receiving greater benefits than non-highly compensated employees (NHCEs).

Safe harbor plans provide a streamlined path to compliance. By following specific rules on employer contributions, vesting schedules, and employee notifications, safe harbor plans automatically satisfy the IRS’s nondiscrimination testing requirements.

Here are the three main nondiscrimination tests:

- **Actual Deferral Percentage (ADP) Test:** Compares the percentage of pay that HCEs and NHCEs contribute to their 401(k) accounts through salary deferrals.

- **Actual Contribution Percentage (ACP) Test:** Compares the percentage of employer matching and after-tax contributions made for HCEs and NHCEs.

- **Top-Heavy Test:** Assesses whether the account balances of key employees make up more than 60% of the total plan assets. If so, the plan is considered “top-heavy” and must meet additional requirements.

If your plan does not qualify as a safe harbor plan, there are limits on how much HCEs—including business owners—can contribute. Specifically, HCEs may only defer about 2% more than the average of all eligible NHCE contributions. If there are no NHCEs participating in the plan, HCEs generally cannot participate either.

The average NHCE deferral percentage also determines HCE contribution limits as follows:

- If NHCEs average between 0% and 2%, multiply that average by two to find the HCE limit.

- If NHCEs average between 2% and 8%, add two to the percentage to establish the HCE limit.

- If NHCEs average greater than 8%, multiply the average by 1.25 to calculate the HCE limit.

Understanding these rules is essential for keeping your plan in compliance and maximizing savings opportunities for everyone in your organization.