Who is an HCE in 401k?

One of the features that make 401(k) attractive as a retirement plan is the high contribution limits. Usually, employees can contribute to the plan up to $19,500 in 2021 and $20,500 in 2022, and still collect an employer's match. However, if you are among the highly compensated employees, your employer could limit the amount you can contribute to your 401(k).

According to the IRS, a highly compensated employee (HCE) is an employee who owned more than 5% of the business at any time in the current or preceding year. You can also be considered an HCE if you earned an income from the business of more than $130,000 in 2021, or $135,000 in 2022, or you were among the top 20% of employees with the highest compensation.

Who is a Highly Compensated Employee?

A highly compensated employee, abbreviated as HCE, must pass the following two tests: 

Ownership test

An employee is classified as a highly compensated employee if they hold more than 5% of the company sponsoring the 401(k) plan in the current year or the preceding year. You must own "more than" 5% of the business and not exactly 5% to be considered an HCE by the IRS.

The 5% threshold combines all equity held by relatives of the employee such as parents, spouse, children, or grandchildren. For example, if you own 3% of the business, and your spouse owns 2.1% of the same business, you will be considered a highly compensated employee since your total stake in the business is 5.1%.

Compensation test

An employee may be considered a highly compensated employee based on the compensation they received from the business. An employee must have received more than $130,000 for 2021 or $135,000 for 2022 in the preceding year. An employee may also be considered an HCE if they were in the top 20% when employees are ranked based on how much they earned from the company.

You must have earned the income as an employee of the sponsoring company to be considered an HCE. If you own more than 5% of the company but you are not an employee, you won’t be considered an HCE of that specific company.

401(k) contribution limits for highly compensated employees

When contributing to a 401(k) plan, you can only contribute up to the annual contribution limit set by the IRS. For 2021, an employee can contribute up to $19,500, while in 2022, the contribution limit is set to $20,500.

Employees above 50 can also contribute an extra $6,500 in catch-up contributions. HCEs may be allowed to contribute up to the annual limit or lower limits, depending on how much non-HCEs contribute to the 401(k)s.

The employer must conduct an annual non-discrimination test to make sure the plan does not favor HCEs over non-HCEs. The non-discrimination tests ensure that the average contribution of HCEs vis-à-vis that of non-HCEs is not more than 2%. Also, the sum of all HCEs contributions cannot exceed double the sum of all non-HCE contributions.

Non-discrimination test

The IRS requires companies offering 401(k)s to conduct a non-discrimination test every year to determine if all employees are treated equally. This test groups employees into highly compensated employees and non-highly compensated employees. The test considers the contributions that employees in each category make to their 401(k)s to determine if the plan discriminates against certain employees in favor of highly compensated employees.

If the company fails the non-discrimination test, the employer must take immediate action to correct the situation to avoid losing its tax-qualified status. The employer can correct the problem by requiring HCEs to withdraw part of their 401(k) contributions, or by making extra contributions to non-HCEs to match HCE contributions.

If the plan loses its tax-qualified status, it could be forced to redistribute all contributions held in the 401(k) plan to the plan participants. The employer may also face severe tax consequences due to the forced distributions of contributions and earnings.

Workaround Strategies for Highly Compensated Employees

If you are an HCE, you can contribute to a 401(k) up to the limit that the employer allows. Here are ways to maximize the amount you save for retirement.

Open a Roth IRA

If your income is below the IRS limits for Roth IRA, you can open a Roth IRA and contribute to it. You will pay taxes upfront on the contributions, but you won't pay taxes in retirement.

Open a Backdoor Roth IRA

If your income exceeds the IRS income thresholds for Roth IRA, you can use the backdoor IRA strategy. This strategy involves contributing to a traditional IRA and later converting it to a Roth IRA.

Set up a Health Savings Account

While an HSA is not a retirement account, it will help you defer paying taxes until a future date. You won't pay taxes on contributions, and your money will grow tax-free over the years. Once you take distributions in the future, you won’t pay income taxes as long as you are using the funds to pay qualified medical expenses.

Open a taxable account

If you are limited in your 401(k) contributions, you can direct part of the money into a taxable account. You can invest in a brokerage account, and allocate your money to multiple investments like stocks, mutual funds, REITs, etc. There are no limits on how much you can contribute to the account.