Highly compensated employee

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Flag of the United States.svg.png This article contains details specific to United States (US) investors. It does not apply to non-US investors.

For the purposes of retirement plans, a highly compensated employee (HCE) is one who owns 5% or more of a company or receives compensation in excess of a predetermined amount. To qualify for tax advantages, retirement plans cannot be overly favorable to highly compensated employees. [1]

According to the IRS, a highly compensated employee is an individual who:

  • Owned more than 5% of the interest in your business at any time during the year or the preceding year, or
  • For the preceding year, received compensation from you of more than $130,000 if the preceding year was 2020 0r 2021, and, if you so choose, was in the top 20% of employees when ranked by compensation.[2][3]

If HCEs contribute too much, an employer can choose among several strategies to bring its plan in compliance with the law. Here are some of the most common:[4]

  • First, an employer may set a percent-of-pay limit within the plan document that HCE contributions may not exceed. The advantage of this strategy is that it removes all doubt about whether a plan will pass its test. The disadvantage is that HCEs could miss out on savings opportunities if the cap ends up being lower than necessary.[4]
  • Second, an employer may restrict HCE contributions when they reach the maximum allowed by the test. In this case, the employer often runs discrimination test projections in the middle of the year, looking for signs that contribution rates will become unbalanced. The advantage of this strategy is that HCEs will be able to contribute the most allowed given the constraints affecting their plan.[4]
  • Third, an employer may choose to refund excess contributions after determining at year-end how much needs to be refunded. Companies using this strategy generally notify their HCEs early on that a refund is likely, and explain why the plan works this way.[4]

Employer cafeteria plans which favor highly compensated employees as to eligibility to participate, contributions, or benefits, must include in their wages the value of taxable benefits they could have selected.[5] Cafeteria plans include Flexible Spending Accounts for health and dependent care, and Health Savings Accounts.

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