Key Takeaways
- HCEs own over 5% or earn above IRS threshold.
- 2025 compensation threshold is $155,000.
- Top-paid group election limits HCEs to top 20%.
- HCE status affects retirement plan nondiscrimination tests.
What is Highly Compensated Employee?
A Highly Compensated Employee (HCE) is defined by the IRS as an individual who either owns more than 5% of a company or earns compensation above a set threshold during the lookback year. This classification is crucial for nondiscrimination testing in employer-sponsored retirement plans to ensure fairness across all employee levels.
HCE status involves specific criteria under IRS Section 414(q), which considers ownership and earnings, including wages, bonuses, and elective contributions. For more on related financial roles, see the C-suite definitions.
Key Characteristics
Understanding the main features of an HCE helps clarify how the classification impacts retirement benefits.
- Ownership Test: Applies if you or your immediate family members hold more than 5% ownership in the company during the determination or lookback year.
- Compensation Test: You qualify if your compensation exceeds the IRS threshold (e.g., $155,000 for the 2025 plan year based on 2024 earnings), potentially limited by a top-paid group election.
- Top-Paid Group Election: Employers may limit HCEs by capping compensation-based qualifiers to the top 20% highest earners.
- Lookback Year: Your HCE status is determined based on compensation or ownership from the prior year, impacting the current plan year.
How It Works
HCE designation directly influences how employers conduct nondiscrimination testing for plans like 401(k)s, ensuring benefits do not disproportionately favor high earners. Employers aggregate compensation across controlled groups when applying the tests.
Once identified, HCEs face contribution limits and testing restrictions that can affect deferrals and employer matching. The IRS updates compensation thresholds annually, requiring employers and employees to monitor earnings closely. For example, evaluating earnings accurately is essential for correct HCE classification.
Examples and Use Cases
Practical scenarios help illustrate HCE classification in various industries.
- Airlines: Executives at Delta and American Airlines earning above the compensation threshold or holding significant ownership are designated as HCEs, influencing their retirement plan contributions.
- High-Yield Dividend Stocks: Investors who hold significant shares in companies listed in the best high-yield dividend stocks may become HCEs if their compensation or ownership meets IRS criteria within those firms.
- Large-Cap Firms: Employees at companies featured in the best large-cap stocks guide often exceed HCE compensation thresholds due to competitive salaries.
Important Considerations
Being classified as an HCE carries implications for your retirement planning and tax situation. You should be aware of potential restrictions on 401(k) contributions and the impact of nondiscrimination testing on your deferral limits.
Employers may elect the top-paid group rule, which can limit the number of HCEs based on compensation rankings, so understanding your status helps anticipate plan limits. Regular review of your compensation relative to IRS thresholds and ownership stakes is advisable to remain compliant and optimize benefits.
Final Words
Highly compensated employee status hinges on ownership and compensation thresholds, impacting retirement plan benefits and compliance. Review your compensation relative to the $155,000 2024 threshold to assess your status and plan accordingly for 2025.
Frequently Asked Questions
A Highly Compensated Employee (HCE) is defined by the IRS as someone who either owns more than 5% of the company or earns above a set compensation threshold during the lookback year. This classification helps ensure retirement plans like 401(k)s do not favor high earners disproportionately.
The IRS uses two main tests: the ownership test, where owning more than 5% of the company qualifies an employee as HCE, and the compensation test, which applies if the employee’s earnings exceed a set threshold based on the prior year’s salary.
For the 2025 determination year, employees who earned more than $155,000 in 2024 are considered Highly Compensated Employees under the compensation test, subject to any employer top-paid group election.
Yes, employers can elect a top-paid group election that limits compensation-based HCEs to the top 20% of employees ranked by compensation. However, those meeting the ownership test remain HCEs regardless of this election.
Yes, ownership attribution rules aggregate stock or profit interests held by family members, meaning family ownership can cause an employee to meet the ownership test and be classified as an HCE.
Officers earning over $230,000 in 2025 (based on 2024 earnings of $220,000) are automatically considered Highly Compensated Employees and may also be classified as key employees under IRS rules, even if they fall below other thresholds.
For initial or short plan years, HCE status is determined using the lookback year compensation compared against the prior year's threshold. This ensures consistent application of HCE rules regardless of employment timing.
