The designation of a Highly Compensated Employee (HCE) is crucial in the realm of retirement savings, particularly when it comes to employer-sponsored plans like a 401(k). The Internal Revenue Service (IRS) defines HCEs based on specific ownership and compensation criteria that help ensure tax advantages are distributed equitably among employees. This article provides an in-depth understanding of HCEs, their implications for retirement plans, and other savings avenues available to them.
Definition of Highly Compensated Employee
According to the IRS, a highly compensated employee is classified under one of these criteria:
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Ownership Threshold: An individual who owned more than 5% of the business at any point during the year or the preceding year, irrespective of their compensation.
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Income Threshold: An employee who received more than $150,000 in compensation in the 2023 tax year or $155,000 in the 2024 tax year and is among the top 20% of employees by compensation.
These benchmarks not only characterize HCEs but also set the stage for contribution limits and nondiscrimination testing in retirement plans.
Key Takeaways for Highly Compensated Employees
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Limited Contributions: The 401(k) contributions of HCEs are subject to limits enforced by IRS regulations to prevent a disproportionate tax advantage for higher earners.
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Nondiscrimination Testing: The IRS mandates annual nondiscrimination testing on 401(k) plans. This process ensures all employees enjoy similar tax advantages from retirement plans, preventing wealthy employees from maximizing benefits at the expense of their non-highly compensated peers.
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Participation Impact: The allowed contribution limits for HCEs directly relate to the participation levels of non-HCE employees in the retirement plan.
Implications of HCE Status
Nondiscrimination Testing
The IRS requires 401(k) plans to undergo a nondiscrimination test to ensure that the benefits are shared fairly. This is done by comparing the average contribution rates of HCEs versus non-HCEs:
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If HCEs' average contributions exceed those of non-HCEs by more than 2%, the plan may fail the nondiscrimination test.
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Additionally, HCEs' contributions must not be more than double the percentage of contributions made by non-HCEs.
Should a plan fail this test, employers might need to return excess contributions made by HCEs, who would then be liable for taxes on these refunds.
Ownership Considerations
Ownership interest is a crucial factor when identifying HCEs. The IRS considers not just direct ownership but also the stakes held by related family members, such as spouses or parents, which can aggregate to meet or exceed the 5% threshold.
Contribution Limits for HCEs
For 2023, HCEs can contribute up to $22,500 to their 401(k) plans, with an additional catch-up contribution of $7,500 available if they are aged 50 and above. In 2024, these limits will increase to $23,000 and $7,500 for catch-up contributions, respectively.
Additional Retirement Savings Options
HCEs can diversify their retirement savings beyond their 401(k) plans through various methods:
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Individual Retirement Accounts (IRAs): In addition to 401(k)s, HCEs can contribute to traditional IRAs, with limits set at $6,500 for 2023 (rising to $7,000 in 2024) and a $1,000 catch-up amount for those over 50.
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Health Savings Accounts (HSAs): If enrolled in a high-deductible health plan (HDHP), HCEs can benefit from tax-advantaged HSAs. Contributions to HSAs grow tax-deferred and can be withdrawn tax-free for eligible medical expenses.
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Brokerage Accounts: While not tax-advantaged, brokerage accounts allow unrestricted investment opportunities, providing liquidity and flexibility without contribution limits.
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Deferred Compensation Plans: These plans enable HCEs to defer portions of their income, although they carry the risk of company insolvency as deferred amounts remain company assets.
Why Being an HCE Matters
Understanding your HCE status is vital for managing your contributions and tax liabilities effectively. If you discover you are classified as an HCE and have contributed beyond the allowed limits, there could be financial implications, including penalties and unexpected tax burdens.
Conclusion
Highly compensated employees play an important role in the efficiency and fairness of employee retirement plans. By understanding the implications of being an HCE and the limits placed on their contributions, individuals can better navigate their retirement planning options. If there's uncertainty about your status or contribution limits, consulting your company’s benefits department can provide clarity and ensure you’re making informed decisions about your retirement savings.