What is a Highly Compensated Employee (HCE)?
The IRS defines a highly compensated employee (HCE) as one who fits one or all of the following:
- Regardless of pay, I have owned more than 5% of the firm during the previous year.
- In 2022, it earned over $135,000 and was in the company’s top 20%. $150,000 is the 2023 tax-year increase.
Understanding High-paid workers
The downside of high pay is restricted 401(k) contributions. Pre-tax donations cut taxable income, but the IRS wants to ensure they don’t favor one set of employees.
HCEs meet the 5% requirement based on voting power or share value. Family members like spouses, parents, children, and grandparents (but not grandchildren or siblings) can also possess an interest.
Having 5% firm ownership does not make an employee highly rewarded. One with 5.01% firm ownership is HCE. An employee with 3% firm ownership is an HCE if their spouse owns 2.2% (making their total interest 5.2%).
The IRS introduced tax-deferred retirement plans like 401(k)s to provide equitable advantages to all workers. All employees may invest as much as they choose, with the company matching up to $20,500 for 2022. They will reach $22,500 in 2023.
High-earners might give more than others. They would benefit more from tax deductions that cut taxable income.
The IRS limited high-earner donations to address this imbalance.
Nondiscrimination test
The IRS mandates a nondiscrimination test for 401(k) programs every year. The exam divides workers into high- and low-paid groups. The compliance test analyzes if the company’s 401(k) plan treats all employees equitably by assessing HCE contributions.
The nondiscrimination rules ensure employee retirement plan tax benefits do not favor highly paid workers.
The plan fails the nondiscrimination criteria if HCEs contribute more than 2% more than non-HCEs.
HCEs cannot contribute more than twice the proportion of regular employees.
Your business can identify you as a highly compensated employee in 2023 if you earn more than $150,000 and rank in the top 20% of employees. Overtime, bonuses, commissions, cafeteria, and 401(k) pay deferrals are compensation.
Others to Consider
The IRS mandates that companies contribute to defined-benefit or defined-contribution plans for employees based on compensation, minimizing the disparity in retirement benefits received by highly and low-compensated employees.
The plan may lose tax-qualified status if an employer fails to fix a disparity. Return all donations to the plan participants. The employer may incur significant financial and tax penalties for distributing contributions and revenues.
A corporation can balance its retirement plans by contributing more to non-high-paid employees. Or, the company might distribute retirement plan withdrawals to high-earners, who must pay taxes.
Highly Compensated Employee 401(k) Contribution Limits
Highly compensated workers can contribute $20,500 to a 401(k) in 2022. They can donate $6,500 in catch-up if they are 50 or older. They can provide $22,500 plus $7,500 as a catch-up in 2023. Alternative Retirement Savings for High-Compensated Workers
Opening an IRA
You may contribute up to $6,000 pre-tax to a regular IRA in 2022 in addition to your 401(k). The catch-up sum remains $1,000, and the figure climbs to $6,500 in 2023.
Contribution deductions decrease and phase out if you or your spouse have a workplace retirement plan and have a particular adjusted gross income. You can still create tax-deferred retirement funds.
Health Savings Account
For those with high-deductible health plans (HDHPs), consider creating an HSA. They provide tax benefits and help you save for unexpected healthcare costs. HSA profits increase tax-deferred with pre-tax contributions. You can buy stocks, bonds, and mutual funds. Its withdrawals are tax-free if used for eligible medical costs.
Register for Brokerage
Though not tax-advantaged, it can help you save more. You may buy many securities, including tax-favored Treasury and municipal bonds. Invest as much as you want and withdraw whenever you want.
Deferred compensation plan
This plan lets you postpone some of your salary and taxes until retirement. There are no deferral restrictions, and investment possibilities are equivalent to a 401(k). You’ll pay taxes on plan distributions after retirement.
Remember that a deferred compensation plan is a corporate asset. Like your 401(k), you don’t own it. If the firm fails, you’ll lose your delayed pay.
A High-Compensated Employee?
The IRS defines a highly compensated employee as someone who owned more than 5% of the business at any time during the year or the previous year (regardless of compensation) or received more than $150,000 in compensation in the previous year, if 2023, and ranked in the top 20% of employees by compensation. Annually, the IRS updates the data.
Why Does It Matter If I’m Well-Paid?
The IRS limits 401(k) contributions for high-earners. If you donate more, you’ll likely get a refund and pay taxes.
The IRS limits contributions for highly compensated employees. Why?
The IRS caps HSE contributions to ensure that 401(k) tax benefits don’t favor high-earners. If HSEs could contribute more than other workers, they may lower their taxable income.
The Verdict
Check with your benefits department to see if you’re well-paid. Double-check your 401(k) contribution limit. Expect to pay higher taxes on your prior year’s contributions.
There may be penalties if you are an HCE and have donated the most. If your firm fails the nondiscrimination test, it may return your excess contributions—taxable income.
Conclusion
- IRS regulations limit highly compensated employees’ 401(k) contributions.
- The IRS wants pre-tax contributions to benefit all employees equally.
- It requires all 401(k) plans to do an annual nondiscrimination test to evaluate if all employees get tax benefits equitably.
- How much an HCE may contribute to their retirement plan depends on non-HCE involvement.
