• A highly compensated employee (HCE) is defined by the IRS based on ownership and compensation tests. Being an HCE can limit how much you may ultimately keep in a tax-advantaged employer plan such as a 401(k).
– Employers must perform annual nondiscrimination testing (ADP/ACP and similar tests) to ensure retirement-plan tax benefits don’t disproportionately favor HCEs. Failure to comply can require corrective distributions or employer contributions and can jeopardize plan tax qualification.
– If you are (or may be) an HCE, there are practical steps to protect and diversify your retirement and tax-advantaged savings: check your status, coordinate with HR/plan administrator, and use IRAs, HSAs, taxable brokerage accounts, or deferred-compensation arrangements where appropriate.
What is a Highly Compensated Employee (HCE)?
The IRS considers a person an HCE if they meet one or both of two tests:
1) Ownership test — they owned more than 5% of the business at any time during the current or preceding year (ownership interest is aggregated with certain family members), or
2) Compensation test — they received compensation above a threshold in the prior year and are in the top-paid 20% of employees. For example, the threshold was $155,000 for 2024 and rises to $160,000 for 2025 (these dollar amounts are adjusted annually).
Practical example of ownership attribution
– An employee who owns 5.01% of a company is an HCE; someone with an exact 5.00% interest is not.
– Ownership attribution includes relatives: if an employee has 3% and a spouse holds 2.2%, their combined interest (5.2%) makes the employee an HCE.
Why it matters: nondiscrimination rules and limits
– The IRS requires retirement plans (like 401(k)s) to pass nondiscrimination tests so tax-deferred benefits don’t favor highly paid employees.
– Tests examine contribution behavior of highly compensated employees (HCEs) vs. non-highly compensated employees (NHCEs). If HCE average deferral percentages are too high relative to NHCEs, the plan fails.
– A failed test may force the employer to correct the plan by: (a) making additional contributions for NHCEs, or (b) returning excess contributions (plus earnings) to HCEs (which creates taxable income for those HCEs). Persistent failures can threaten a plan’s tax-qualified status.
Nondiscrimination testing in plain terms
– Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests compare average deferral/matching rates between NHCEs and HCEs.
– A simple rule of thumb (one of the common failure thresholds): if the average HCE deferral rate exceeds the NHCE rate by more than roughly 2 percentage points, or if HCE average deferral is more than twice the NHCE rate, corrective action is needed. (Exact calculations vary by test and plan specifics.)
Contribution limits and numbers to know (2024–2025)
– 401(k) elective deferral limits for individuals: $23,000 for 2024 and $23,500 for 2025 (catch-up contributions of $7,500 if age 50+ are additional).
– IRA contribution limit: $7,000 in 2024 and 2025 (plus $1,000 catch-up at age 50+). Note: the ability to deduct traditional IRA contributions phases out if you (or your spouse) participate in a workplace retirement plan and your AGI exceeds certain amounts.
– Ownership and compensation thresholds that define HCE status are adjusted by the IRS annually (e.g., $155,000 for 2024 compensation test; $160,000 in 2025).
What happens if you contribute too much because you’re an HCE?
– If nondiscrimination testing requires corrective refunds, excess elective deferrals made by HCEs may be returned to them and will be taxable in the year of contribution (and possibly subject to corrective paperwork).
– Employers typically notify affected employees and coordinat e corrective distributions; ask HR or the plan administrator if you believe you might be impacted.
Practical steps for employees who are (or might be) HCEs
1) Confirm your status
• Ask your company’s benefits or payroll department whether you are classified as an HCE and whether your plan historically passes ADP/ACP tests.
• Review any annual notices from the plan administrator — plans often inform participants of required corrective distributions.
2) Monitor and adjust 401(k) deferrals
• If your plan is at risk of failing tests, you may reduce elective deferrals to avoid corrective refunds (coordinate with HR for timing and implications).
• If you’re approaching the compensation threshold that could make you an HCE next year, consider running projections with your payroll/benefits team.
3) Maximize other tax-advantaged accounts
• Traditional IRA: up to $7,000 in 2024–2025 (deductibility depends on workplace-plan participation and income levels).
• Health Savings Account (HSA): if eligible (on a high-deductible health plan), contribute pre-tax to an HSA — growth is tax-deferred and qualified medical withdrawals are tax-free.
• Employer-sponsored deferred compensation plans: if available, these can defer additional income beyond 401(k) limits, but they are unsecured company liabilities (a risk if the employer becomes insolvent).
4) Use taxable (brokerage) accounts for flexible saving
• If tax-advantaged routes are constrained, invest in taxable accounts, where there are no contribution limits or distribution restrictions. Optimize tax efficiency by using tax-aware investments (e.g., municipal bonds for tax-free interest, tax-loss harvesting).
5) Mental checklist and coordination
• Coordinate with your spouse if they hold company stock or interests that could change your aggregated ownership test.
• If you are age 50 or older, remember catch-up contributions available for retirement accounts.
Practical steps for employers and plan sponsors
1) Run required nondiscrimination tests annually (ADP/ACP). Many employers outsource these calculations to plan recordkeepers or third-party administrators.
2) If tests indicate a failure, correct promptly by:
• Returning excess elective deferrals to HCEs (with required tax reporting), or
• Making corrective contributions for NHCEs (sometimes preferable to retain HCE deferrals).
3) Communicate proactively with employees — tell HCEs if corrective distributions are likely and explain options.
4) Consider plan design changes (safe-harbor provisions, automatic enrollment, employer contributions) that can simplify compliance and reduce the risk of failure.
Important considerations and caveats
– Compensation includes salary, bonuses, commissions, overtime, and salary deferrals toward cafeteria plans and retirement deferrals.
– IRS rules and dollar thresholds change annually; always confirm current limits.
– Deferred compensation plans are unsecured company liabilities — you are subject to employer-credit risk.
– If unsure about tax consequences or plan options, consult your company’s plan administrator or a tax/financial advisor.
Bottom line
Being labeled an HCE is determined by clear IRS ownership and compensation tests. The designation matters because it affects how much of your salary you can ultimately keep in tax-favored employer plans without triggering corrective actions. If you are (or may become) an HCE, proactively confirm your status with HR, monitor deferral levels, and diversify your savings strategy using IRAs, HSAs, taxable accounts, or—where appropriate—deferred compensation. Employers must manage plan design and testing to ensure fairness and maintain qualified-plan tax status.
Source
This article is based on Investopedia’s explanation of Highly Compensated Employees (Investopedia / Zoe Hansen). For the original article and further details, see
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.