Summary: Highly Compensated Employees (HCE) are those team members paid the highest amount (whether in cash, equity or benefits), and receive a different tax treatment from the IRS.
Almost everyone wants to be a highly valued employee, paid a huge salary, or a part-owner of a business that makes great annual profits. Of course, though, it’s all relative.
What constituted a really attractive salary just a few decades ago is now middle-of-the-road, and owning a successful business doesn’t necessarily mean you’ll share in all of its financial gains.
The people who really do share top positions are classified as highly compensated employees by the IRS, and because they make so much, certain restrictions are placed on their earnings.
This article will delve into these restrictions and define what makes an employee highly compensated.
What is a Highly Compensated Employee?
According to the Internal Revenue Service (IRS), a highly compensated employee or HCE is someone who fits one or both of these criteria:
- Owns more than a 5.0% stake in their employer’s business in the previous year no matter how much salary and other compensation they received
- Was paid a gross income in excess of an annual limit set by the IRS, and was in the top 20% of employees based on compensation from their employer
The rationale behind these criteria is that HCEs can be compensated with stock options that are highly valuable or make a lot more money than the average employee.
The IRS continually updates the threshold amount for determining HCEs. Employees in 2025 who made more than $155,000 in 2024 are considered HCEs. Employees who are receiving more than $160,000 in 2025 will be considered HCEs for 2026.
Why Is the Determination of Highly Compensated Employees Important?
The idea behind differentiating HCEs from other employees is to ensure fairness for all contributors to 401(k) retirement plans.
These 401(k) plans were created to provide workers with appropriate ways to save funds for retirement, both parts of their own salaries and (not necessarily matching) contributions from their employers.
These retirement plans are tax-advantaged, whether that means contributions come from pre-tax income, as in the case of traditional plans, or that earnings and distributions are not taxed later, in the case of Roth 401(k) plans.
However, the IRS is concerned that tax deferral may unfairly benefit people in higher income categories. It therefore limits the contributions of highly compensated employees to their 401(k) plans to help maintain a fair and equal benefit for all employees from these tax-deferred plans.
Differentiating Highly Compensated Employees from Other Employees
The IRS uses two tests to determine whether an employee is or is not an HCE. These include an ownership test and a compensation test as follows:
Ownership test
The amount of the company or 401(k) plan sponsor that the employee owns in the plan year or the lookback year (the 12-month period prior to the start of the plan year). According to the IRS, if the person in question is an employee during the plan year and owns over 5% of the company during the plan year or the lookback year, this employee is an HCE.
Importantly, the ownership test can include not only the employee in question but also their immediate family, including their spouse, children, and grandchildren. If the total ownership of these family members exceeds 5% during the plan or lookback years, the employee can be considered an HCE.
Compensation test
The compensation test is relatively simple and is based on the gross compensation the employee received during the plan year or the lookback year. Gross compensation is represented by more than just salary, however.
It includes regular wages but also overtime payments, tips, bonuses, commissions, and other earnings. The employer should calculate the employee’s total gross compensation and determine if it was over $155,000 for 2024 or over $160,000 for 2025.
The employer can also use a determination of the employee being in the top 20% of employees based on compensation. If the employee meets the first or both of these levels, they are an HCE.
Differentiation Examples
To help clarify how HCEs are differentiated from non-HCEs, let’s explore the following three examples:
Example 1 – Family Ownership
Janet works for Stuff Corporation in the 2025 plan year and has also owned a 2% stake in the company since 2020. Janet’s son, Brad, owned a 3.5% stake in Stuff Corporation in 2024 but sold his stake entirely in 2025. By the ownership test, Janet is an HCE since she and her son together owned 5.5% of the company in the 2024 lookback year.
Example 2 – High Compensation
Frank is an executive at Things and Such Co. and takes in an annual salary of $150,000. In 2024, he also received a performance bonus of $6,000. In 2025, the plan year, he is expecting to earn a larger bonus of $8,000. Frank’s total compensation for the 2025 plan year would be $158,000 and under the year’s threshold. However, he earned $156,000 in 2024, the lookback year, and therefore Frank is an HCE.
Example 3 – Short Plan Year
Pat starts working for Services Inc. in July 2025 on a salary of $180,000/year. In November, the company changes its 401(k) plan, creating a short plan year from November 1 to December 31 and then starting a new year for the 2026 calendar year. Pat’s compensation for the lookback year (the 12 months prior to November) does not exceed the threshold because they started only halfway through 2025 and earned only $90,000. Therefore, Pat is not an HCE. However, this will likely change for the next year.
How Being an HCE Limits 401(k) Contributions
The 401(k) contribution limit for all employees in 2025 is $23,500, up from $23,000 in 2024. The combined defined contribution limit for employees and employers is $70,000, up from $69,000 last year, and the catch-up contributions for 2025 for employees over age 50 are $7,500 and $11,250 for employees aged 60 to 63. Employees can normally decide how much to contribute up to these limits and take on the risks for doing so.
However, highly compensated employees can have their contributions limited so that they don’t receive more tax advantages than the other people in their plans. The IRS requires all traditional 401(k) plan sponsors to test their plans to ensure that the contributions to these plans are fair and proportional to the salaries of all employees.
Non-discrimination tests are used to make sure that HCEs are not unfairly benefiting from the tax advantages of their plans over non-HCEs. If a plan doesn’t pass a non-discrimination test, limits can be placed on HCEs’ contributions. If they’ve already contributed in excess of these limits, their contributions will be refunded and will thus become taxable income.
Non-Discrimination Tests
The IRS uses two tests to determine if a plan unfairly benefits HCEs or not. If a plan fails to pass both of these tests, it can be corrected by returning excess contributions within two-and-a-half months. If this correction doesn’t occur, the plan can lose its tax-qualified status.
Actual Deferral Percentage (ADP) Test
The ADP test is based on elective deferrals for both traditional and Roth 401(k) plans, but doesn’t count catch-up contributions. Each plan participant’s actual deferral ratio (ADR) is calculated following this equation:
Actual deferral ratio = elective deferrals/compensation
Once the ADR of each participant is calculated, it is used to find the average ADP (actual deferral percentage) of the HCE group and the non-HCE group. The test fails if:
- The ADP for the HCE group is greater than 125% of the non-HCE group’s ADP, or
- The ADP of the HCE group is more than the non-HCE group’s ADP plus 2%
Actual Contribution Percentage (ACP) Test
The ACP test is based on all contributions, including matching and after-tax contributions. To find each employee’s actual contribution ratio, follow this equation:
Actual contribution ratio = contributions/compensation
Next, find the average of these ARCs to arrive at the ACP (actual contribution percentage) of the HCE group and the non-HCE group. This test fails if:
- The ACP for the HCE group is more than 125% of the non-HCE group’s ACP, or
- The ACP of the HCE group is more than the non-HCE group’s ACP plus 2%
When plans fail these tests, excess contributions made by HCEs must be returned to them as taxable income.
The Last Word on Highly Compensated Employees
HCEs are those employees, owners, and managers who own more than 5% of a company sponsoring a 401(k) plan or take in more than $160,000 in 2025.
To make 401(k) contributions equitable, the IRS requires plan sponsors to test their plans annually to ensure that HCEs aren’t gaining disproportionate advantages from them over non-HCEs. As an HCE, this would mean that your 401(k) contributions could be limited, and if paid in excess, they may have to be returned to you.
FAQ
Yes, each year, the plan sponsor must test its 401(k) plan, which includes dividing employees into HCE and non-HCE groups. However, once an employee is characterized as an HCE, there is no need to recalculate their earnings each year, and they can instead be considered an HCE going forward.
Yes, there are various strategies to make tax-advantaged contributions. For example, employees can contribute to Roth IRAs (individual retirement accounts) or Health Savings Accounts to gain tax advantages. They can also enter into deferred compensation plans, which put off their earnings to be paid to them at a later date.