Highly Compensated Employee (HCE)

Definition

A Highly Compensated Employee (HCE) is a classification used in the context of employee benefit plans, particularly retirement plans, to identify employees who are among the higher earners within an organization. This designation is important for ensuring compliance with non-discrimination rules set by the Internal Revenue Service (IRS) and the Department of Labor (DOL) in the United States.

Key Components

1. Compensation Threshold: The IRS sets a specific compensation threshold that determines whether an employee is considered highly compensated. This threshold can change annually based on inflation adjustments.
2. Ownership Interest: An employee who owns more than 5% of the company at any time during the year or the preceding year is considered an HCE, regardless of their compensation level.
3. Top-Paid Group: Employees who are in the top 20% of earners within the company may also be classified as HCEs, depending on the employer’s election to apply this rule.

Importance in Retirement Plans

The classification of HCEs is crucial for the administration of retirement plans like 401(k)s. It ensures that the benefits of these plans do not disproportionately favor higher-paid employees over lower-paid employees.

Non-Discrimination Tests

1. Actual Deferral Percentage (ADP) Test: Ensures that the average deferral rate of HCEs does not significantly exceed that of non-HCEs.
2. Actual Contribution Percentage (ACP) Test: Similar to the ADP test but applies to employer matching and after-tax contributions.
3. Top-Heavy Test: Determines if the plan assets are concentrated among key employees, which can trigger required minimum contributions for non-key employees if a plan is deemed top-heavy.

Compensation Threshold

• For the year 2023, an employee is considered highly compensated if they earned more than $135,000 in the preceding year.
• The IRS reviews and adjusts this threshold periodically.

Example Scenario

Identification of HCEs

1. Compensation-Based: In 2023, an employee who earned $140,000 in 2022 would be classified as an HCE.
2. Ownership-Based: An employee who owns 6% of the company, even if their salary is below the compensation threshold, is considered an HCE.
3. Top-Paid Group: If a company elects the top-paid group rule and an employee is in the top 20% of earners, they may also be classified as an HCE.

Implications for Employers and Employees

Employers

• Compliance: Employers must ensure that their retirement plans comply with non-discrimination requirements by properly identifying HCEs and conducting the necessary tests.
• Plan Design: Employers may design their retirement plans to pass non-discrimination tests, potentially including corrective actions like refunds or additional contributions.

Employees

• Contribution Limits: HCEs may face limits on their contributions to retirement plans if the plan fails non-discrimination tests, resulting in potential refunds of excess contributions.
• Benefit Restrictions: HCEs might experience restrictions on plan benefits compared to non-HCEs to ensure the plan complies with non-discrimination rules.

Conclusion

Highly Compensated Employee (HCE) classification is a critical concept in retirement plan administration, ensuring that benefits are equitably distributed among all employees. By understanding the criteria and implications of being an HCE, both employers and employees can better navigate the complexities of retirement plan compliance and benefit management.