Highly Compensated Employee (HCE): Definition, Rules, and Options

What is an HCE?

A Highly Compensated Employee (HCE) is an IRS designation used to ensure employer retirement plans (like 401(k)s) do not disproportionately favor top earners. You are an HCE if you meet either condition during the year (or the preceding year):

• You owned more than 5% of the business at any time, regardless of compensation.
• You received compensation above the IRS threshold and rank among the company’s top 20% by pay. The threshold is $155,000 for 2024 and increases to $160,000 for 2025.

Ownership is measured by interest or voting power and includes certain relatives’ holdings (spouse, parents, children, grandparents), which can push combined ownership over the 5% limit.

Why HCE status matters

HCEs face limits and extra scrutiny because pre-tax retirement contributions reduce taxable income. The IRS requires nondiscrimination so tax advantages don’t primarily benefit high earners. If a plan fails testing, excess contributions may be returned and taxed, and the employer could face penalties or plan disqualification.

Nondiscrimination testing — how it works

All employer 401(k) plans must run annual nondiscrimination tests that compare HCEs to non-HCEs. Key rules include:

• If the average contribution rate of HCEs exceeds the average for non-HCEs by more than 2 percentage points, the plan likely fails.
• HCE group contributions (as a percentage) generally cannot exceed twice the percentage of non-HCE group contributions.

Compensation counted toward HCE status includes salary, overtime, bonuses, commissions, and certain deferrals (e.g., into cafeteria plans and 401(k)s).

Consequences and corrective actions

If a plan fails nondiscrimination testing or other qualification rules, employers can correct imbalances by:

• Making additional employer contributions for non-HCEs, or
• Refunding excess contributions to HCEs (those refunds are taxable to the recipient).

Failure to correct issues can risk the plan’s tax-qualified status and lead to adverse tax and financial consequences for the employer and participants.

Contribution limits and catch-up amounts

Typical limits for employee elective deferrals:

• 401(k) employee deferral limit: $23,000 for 2024; $23,500 for 2025.
• 401(k) catch-up (age 50+): additional $7,500.
• Traditional IRA contribution limit: $7,000 for both 2024 and 2025; catch-up $1,000.

Note that the HCE designation affects nondiscrimination testing and potential adjustments — not the statutory dollar maximums themselves. If your plan fails testing, excess contributions can be returned regardless of the legal deferral limit.

Other retirement and savings options for HCEs

If nondiscrimination rules or plan design limit your ability to shelter income, consider additional vehicles:

• Traditional or Roth IRA — may be subject to income-phaseout rules for deductibility.
• Health Savings Account (HSA) — pre-tax contributions, tax-deferred growth, tax-free withdrawals for qualified medical expenses (requires a high-deductible health plan).
• Taxable brokerage account — no contribution limits and flexible access; consider tax-efficient investments (municipals, Treasuries).
• Deferred compensation plans — let you defer additional pay until a later date, but these are unsecured company obligations (risk if the employer becomes insolvent).

Practical tips

• Ask your HR/benefits department whether you are classified as an HCE and how your employer runs nondiscrimination testing.
• Confirm which types of pay your employer counts as compensation for HCE determination.
• Monitor your contributions: if a plan fails testing, excess elective deferrals may be refunded and become taxable income.
• If limited by plan design, explore IRAs, HSAs, brokerage accounts, or employer deferred compensation (weighing liquidity and credit risk).

FAQ (short)

Q: How is the 5% ownership calculated?
A: It includes your direct interest plus certain relatives’ holdings (spouse, parents, children, grandparents). Ownership is measured by voting power or value of company shares.

Q: What counts as compensation for the HCE threshold?
A: Salary, overtime, bonuses, commissions, and deferrals to cafeteria plans and 401(k)s are typically included.

Q: What happens if my employer’s plan fails the nondiscrimination test?
A: The employer must correct the failure (e.g., make additional contributions for non-HCEs or refund excess HCE deferrals). Refunded amounts are taxable to the employee.

Bottom line

HCE designation affects how retirement-plan benefits are tested and may limit practical access to tax-advantaged deferrals. Confirm your status with your employer, monitor plan testing outcomes, and use alternative saving vehicles if needed.