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Summary: A highly compensated employee (HCE) owns at least 5% of the company and earns more than the federal predetermined compensation limit.
Understanding highly compensated employee status is important to businesses. Here we explain what it is and its impact on an organization.
Highly Compensated Employees (HCE)
A highly compensated employee (HCE) earns compensation above a particular threshold and has benefits within a company. Understanding who falls into the category of an HCE is important for organizations that must comply with regulations and plan employee benefits such as retirement. HCE employees are subject to different 401(k) contributions based on their earnings.
According to the IRS, an individual is an HCE if they satisfy an ownership test and a compensation test.
An ownership test means that the employee owned at least 5% of the business during the year or the previous year, irrespective of their compensation.
The compensation test is if an employee received above $150, 000 in the year 2023 and if they fall into the top 20% of employees with the highest compensation. The amount for compensation changes every year.
Importance of HCE Classification
Identifying employees with an HCE status can help the organization fairly distribute benefits such as retirement plans. The importance of HCE classification is considered below:
1. Impact on retirement plan compliance
The HCE status determines whether individuals with high stakes in the company are benefiting unfairly or disproportionately from 401(k) retirement plans. The IRS restricts the contributions for a 410(k) retirement plan if an employee has earned an HCE status. The purpose of identifying HCEs is to guarantee compliance with the legal framework of the IRS. If these tests are not performed and employers are non-compliant with these regulations, it could lead to tax penalties and affect the retirement savings of employees.
2. Non-discrimination testing and benefits
To avoid issues of non-compliance, employers are encouraged to pursue non-discrimination testing (NDT). The NDT determines whether the contribution rate of HCEs matches that of regular employees who are not categorized as highly compensated. Initially, employees could contribute what they wanted to their retirement plans, and this sum would be matched by the employer. This means that higher-earning employees could pay far more into these plans, which gave them the benefit of a higher tax deduction compared to tax-paying employees with a lower income. The purpose of performing the NDT annually is to ensure that equal benefits are provided to all employees.
When employers make contributions toward a 401(k) retirement plan, it is tax deductible. Managing HCE contributions will prevent employers from benefiting from tax incentives that do not comply with the legal framework of the IRS.
Challenges and Considerations for HCEs
Understanding the challenges for HCEs can help organizations adhere to regulations and guarantee their compliance with the IRS and Department of Labor. Challenges of compliance and equality are as follows:
1. Regulatory compliance
If an employer and employee are not compliant with retirement plan contributions and benefits based on the HCE status of employees, they will both face tax penalties.
2. Balancing compensation strategies
The IRS places restrictions on HCE contributions to prevent higher-paid employees from taking advantage of tax benefits. If HCE individuals can make higher retirement plan contributions compared to other employees, they will significantly reduce their taxable income. Compensation strategies require consistent evaluation and adjustments. This includes equity audits and disclosures concerning retirement savings plans and benefits to the IRS and relevant authorities. These steps can assist employers in balancing their compensation strategies.
Best Practices for Managing HCEs
Implementing the best practices for managing HCEs will keep companies compliant and encourage fair and equitable compensation planning. These strategies include:
1. Compensation planning
As part of the best practice, an employer can adhere to non-discrimination rules when creating a compensation or benefit plan. The level of benefits provided to employees should depend on the classifications of the employee, such as full-time employment, location, and position. These requirements must be reviewed by the employer to ensure that HCE individuals are not favored. Identifying which employees qualify as HCE requires the development of a plan detailing the different levels and rates of employee contributions. Non-discrimination tests can ensure that these plans are compliant with the law.
2. Ensuring equitable benefits distribution
Employers must perform reviews and audits of employee compensation and benefits to ensure equitable distribution. Employers must ensure that the average contributions of HCEs do not exceed 2% of the average contributions of non-HCE employees, or the company will be non-compliant. By carefully assessing employee compensation and benefits, companies can classify individuals as HCE or non-HCE and adhere to financial regulations.
Wrapping Up HCEs
Highly compensated employees, or HCEs, are high-earning individuals who are subject to restrictions by the IRS. The purpose of the compensation regulation is to prevent HCE individuals from taking advantage of tax deductions more so than non-HCEs. Employers have a pivotal role to play in ensuring that they remain compliant with HCE law by reviewing and comparing employee wages and benefits. Full disclosure of earnings to regulatory authorities such as the IRS can avoid issues of non-compliance that will lead to penalties, including refunding employee contributions.
FAQ
When you are classified as an HCE, your 401(k) contributions will be limited. This means that even if an employee earns a higher salary and is eligible for additional benefits, they cannot pay more into their retirement plan, which would place non-HCEs at a disadvantage when it comes to tax deductions. The amount that an HCE can contribute to a retirement plan will depend on how much non-HCEs can contribute. Individuals with HCE status may want to explore alternatives to grow their retirement plan to ensure that they are making the most out of their benefits.
An HCE is an individual who falls within the bracket of the highest-paid employees in the company, usually the top 20%. They may be a shareholder that owns over 10% of employer stock and receive a compensation of $150,000 or more. Non-HCEs are not subject to restrictions on retirement planning, such as 401(k) contributions, as they pay the minimum or standard contribution based on their earnings.