Highly Compensated Employee (HCE)

What Is a Highly Compensated Employee (HCE)?

A highly compensated employee (HCE) is, as per the Internal Revenue Service, any individual who has done one of the accompanying:

• Owned over 5% of the interest in a business whenever during the year or the previous year, paying little heed to how much compensation that person earned or received
• Received compensation from the business of more than $130,000 assuming that the previous year is 2021 (and more than $135,000 in the event that it is 2022), and in the event that the employer so decides, was in the top 20% of employees when positioned by compensation

Seeing Highly Compensated Employees (HCE)

Tax-deferred retirement plans, for example, 401(k) plans were carried out by the Internal Revenue Service (IRS) to offer equivalent benefits to all workers. Initially, all employees could contribute however much they need, with total contribution matched by the employer up to $19,500 every year for 2021 and $20,500 for 2022.

High earners could contribute significantly more than different employees and were subsequently prone to benefit more from the tax-free plan, which permitted them to extensively bring down their tax liabilities. Seeing that not all employees were getting equivalent benefits from retirement plans, the IRS set rules against high earners offering over a certain limit in view of the average contribution of different employees.

Nondiscrimination Test

The Internal Revenue Service (IRS) expects that all 401(k) plans take a nondiscrimination test consistently. The test isolates employees into two groups — non-highly compensated and highly compensated employees (HCE). By analyzing the contributions made by HCEs, the compliance test decides if all employees are dealt with similarly through the company's 401(k) plan.

The non-discrimination limitations are set in place so employee retirement plans don't separate for highly compensated employees. Characterizing highly compensated employees gave a way to the IRS to manage deferred plans and guarantee that companies were not just setting up retirement plans to benefit their executives.

The 5% threshold depends on voting power or the value of company shares. The interest owned by an individual likewise incorporates the interest credited to their family members like spouse, parents, children, grandparents, however not grandchildren or kin. An employee with precisely 5% ownership in the company isn't viewed as a highly compensated employee, while one with a 5.01% interest in the company has the HCE status. For instance, an employee with 3% holdings in the company will be viewed as a HCE in the event that their spouse claims 2.2% interest in a similar company. (Total interest is 5.2%).

Special Considerations

Assuming the average contributions of HCEs to the plan are over 2% higher than the average contributions of non-HCEs, the plan would fail the non-discrimination test. Furthermore, contributions by HCEs as a group can't be multiple times the percentage of other employee contributions.

How much a HCE can add to their own retirement plans relies upon the level of non-HCEs participation in the plan.

In easier terms, when a company adds to a defined-benefit or defined-contribution plan for its employees and those contributions depend on the employee's compensation, the IRS expects that the company limit the disparity between the retirement benefits received by highly compensated and lower compensated employees.

Assuming the employer fails to address the discrimination, the plan could lose its tax-qualified status and all contributions should be rearranged to the plan's participants. The employer could likewise face serious financial and tax outcomes because of distributing the contributions and earnings.

A company can address any imbalance in its retirement plans by making extra contributions for the non-highly compensated group of employees. On the other hand, the firm could make distributions to the HCE group, which should make withdrawals from the plan and pay taxes on the withdrawals.

Highlights

• A highly compensated employee is defined as an employee that possesses over 5% of the interest in a business whenever during the year or the previous year.
• How much a HCE can add to their own retirement plans relies upon the level of non-HCEs participation in the plan.
• By looking at the contributions made by HCEs, the federal government compliance test decides if all employees are dealt with similarly through the company's 401(k) plan.