What’s the Definition of a Highly Compensated Employee?

There are several differences between highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). It’s important for HR professionals to understand the definition of a highly compensated employee for tax reasons, benefits, and legal purposes.

So, what exactly is an HCE? The definition states that it's an employee who meets one of the following scenarios:

• He or she owns 5 percent of the company providing the benefits plan
• She or he earned more than $120,000 during the previous tax year

Although these are the basic qualifying factors for HCEs, there’s still much more to know. Let's dive in.

What's the definition of a highly compensated employee in 2019?

The income brackets for qualifying HCEs are different depending on the year. Since employees are classified based on the income from the previous year’s tax return, make sure you’re looking at the requirements for the right year. In 2019, the HCE threshold will increase to $125,000 (from $120,000 in 2018). For previous years’ requirements refer to the COLA Table.

On the other end of the spectrum, non-highly compensated employees (NHCEs) are individuals who own less than 5 percent of the company or make less than the above income thresholds. Employees are classified by third-party administrators who perform nondiscrimination tests, such as the Ownership Test and the Compensation Test.

How much can highly compensated employees contribute to a 401(k)?

A 401(k) is one of the most preferred retirement programs available to employees. The plan allows higher contributions than most other programs and some companies even offer additional matching contributions. However, it’s important to understand that there are contribution limits for HCEs.

According to Good Financial Cents, “contributions made by HCEs can’t be excessive when compared to those of non-HCEs. For example, if the average plan contribution by non-HCEs is 4%, then the most an HCE can contribute is 6%.” Therefore, an employee who earns $150,000 planning to contribute $18,500 will only be allowed to invest $9,000, or 6 percent of their salary due to HCE limits.

If an HCE contribution exceeds these limits, they will be issued a refund at the end of the year. The employee will be required to pay income tax on the additional funds, raising the amount they owe. Failing to comply with these limits also means the organization will fail nondiscrimination testing. Companies who fail these tests will be held responsible for restructuring their benefits plan to ensure employee classification and plan terms comply with The Employee Retirement Income Security Act (ERISA).

Nondiscrimination tests are performed by March 15th to ensure 401(k) plans are compliant. If there is a compliance issue and it isn’t corrected within the specified timeframe, there can be further complications. The IRS takes the ERISA Act very seriously. Failure to comply could mean that the 401(k) plan loses its tax-qualified status.

These issues highlight the importance of understanding highly compensated employees. Get to know these 401(k) plan limits and tax responsibilities to avoid discrimination and loss of retirement funds from company errors.

Have more questions about the definition of a highly compensated employee or nondiscrimination tests? Contact a TriNet Advisor today. We are here to help you navigate the challenging world of HR.