What Is a Highly Compensated Employee (HCE)?

A Highly Compensated Employee (HCE) classification is a concept within the Internal Revenue Code (IRC) that plays a significant role in the administration of employer-sponsored retirement plans. This designation ensures that qualified plans, such as 401(k)s, do not unfairly benefit a small group of high-earning individuals at the expense of the broader employee base. The HCE classification is fundamental for conducting annual non-discrimination testing, which is mandated to maintain a plan’s tax-qualified status.

Defining a Highly Compensated Employee

For the 2025 plan year, an employee is considered an HCE if they received more than $155,000 in compensation from the employer during the preceding calendar year, 2024. This compensation threshold is adjusted annually by the Internal Revenue Service (IRS) to account for cost-of-living increases.

Alternatively, an employee is designated an HCE if they owned more than 5% of the employer’s business at any point during either the current plan year or the immediately preceding plan year. Direct and indirect ownership interests are considered.

The IRS also applies family attribution rules when determining ownership percentages. This means that an employee is considered to own any interest held by their spouse, children, parents, or grandparents. For example, if an employee holds a 3% ownership stake but their spouse owns 2.2% in the same company, the employee is deemed to own 5.2%, thereby meeting the HCE ownership criterion. These attribution rules ensure that ownership cannot be fragmented to avoid HCE classification.

Implications of HCE Status for Retirement Plans

The classification of Highly Compensated Employees is particularly important for qualified retirement plans because the IRS mandates annual non-discrimination testing. These tests ensure that the plan does not disproportionately favor HCEs over Non-Highly Compensated Employees (NHCEs). The primary tests include the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test.

The ADP test specifically examines the average rate of elective deferrals, including pre-tax and Roth contributions, made by HCEs compared to those made by NHCEs. Similarly, the ACP test scrutinizes employer matching contributions and any after-tax employee contributions. Both tests compare the average contribution rates of the HCE group to the NHCE group, typically requiring the HCE average to be within a certain percentage range, often not exceeding 125% or two percentage points higher than the NHCE average.

If a retirement plan fails either the ADP or ACP test, corrective action is necessary to maintain the plan’s tax-qualified status. The most common correction method involves refunding excess contributions to the affected HCEs. These refunds, which include any associated earnings, are typically taxable to the HCE in the year they are distributed.

Employers face a 10% excise tax on the excess contribution amounts if corrections are not completed within 2.5 months following the end of the plan year being tested. While the absolute deadline for correction to avoid plan disqualification is typically 12 months after the plan year end, the excise tax penalty encourages earlier resolution. Another corrective measure is for the employer to make Qualified Nonelective Contributions (QNECs) to the NHCEs, effectively raising their average contribution rates to pass the tests.

Advanced Considerations for HCE Determination

Beyond the standard definition, certain advanced rules can impact HCE determination. An employer may choose to implement a “top-paid group election,” which is an optional provision. This election limits the group of HCEs, based on compensation, to the top 20% of all employees ranked by their compensation in the preceding plan year. It is important to note that this election solely affects the compensation test; employees who meet the 5% ownership test are always considered HCEs regardless of their compensation rank.

The concept of “controlled groups” also influences HCE determination. When a business is part of a controlled group, such as a parent-subsidiary or brother-sister relationship, all employees across all entities within that group are treated as if they work for a single employer. This rule prevents employers from structuring their businesses in a way that would circumvent HCE classification and the associated non-discrimination testing requirements.

For new businesses or during a plan’s initial year of operation, when a full preceding year’s data is unavailable, HCE status for the compensation test can be determined based on compensation during the current plan year. However, the 5% ownership test still applies by considering ownership at any point during the current or preceding year. These specific rules ensure that even in unique circumstances, the integrity of the HCE classification and non-discrimination principles is maintained.