Definition of Highly Compensated Employee (HCE)
A Highly Compensated Employee (HCE) is an employee defined by the Internal Revenue Service (IRS) as one meeting either or both of the following conditions:
- Owned more than 5% of the business in the current or preceding year, regardless of their compensation level.
- Received more than $150,000 in compensation during the tax year 2023 and also was in the top 20% of employees ranked by compensation. This threshold increases to $155,000 for the 2024 tax year.
HCEs face limitations on their 401(k) plan contributions as the IRS aims to ensure tax benefit fairness among all employees. The participation of non-HCEs in retirement plans directly influences how much an HCE can contribute to their retirement plan.
HCE vs Non-HCE Comparison
| Aspect | Highly Compensated Employee (HCE) | Non-Highly Compensated Employee (Non-HCE) |
|---|---|---|
| Ownership | Owns >5% of the business | Owns <5% |
| Compensation Threshold (2023) | >$150,000 | ≤ $150,000 |
| Participation Impact | Limited contribution in 401(k) | No specific limitations |
| IRS Testing | Subject to nondiscrimination tests | Not subject to the same experimental scrutiny |
| Top 20% Criterion | Must be in this category | Limited to the bottom 80% |
Related Terms
- 401(k) Plan: A retirement savings plan sponsored by an employer allowing workers to save and invest a portion of their paycheck before taxes are taken out.
- Nondiscrimination Test: An IRS-required test ensuring that 401(k) plans do not disproportionately benefit HCEs over non-HCEs.
- Compensation: Total earnings before taxes or other deductions, it can include salaries, bonuses, and overtime.
Funny Examples
- Why did the HCE bring a ladder to the office? Because they wanted to reach new heights in contributions… but the IRS had other ideas!
- Why don’t HCEs like to play hide and seek? Because good luck hiding when you’re in the top 20%!
Diagram - HCE Contribution Limit Influence:
graph TD;
A[HCE Status] --> B[5% Ownership or Top 20% Earnings];
B --> C{Influences Contribution Limits};
C -->|High Non-HCE Participation| D[Higher Contribution Limit Allowed];
C -->|Lower Non-HCE Participation| E[Lower Contribution Limit Allowed];
Humorous Citations
- “Being a Highly Compensated Employee is like being the kid chosen for dodgeball – you have impressive perks, but you’ve also got a target on your back!” 🤣
- “HCEs earn more but also must dodge IRS regulations like they’re playing a game of financial Twister!” 🎉
Frequently Asked Questions
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How are HCEs determined? HCEs are determined based on ownership stakes or high compensation levels as defined by the IRS.
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What happens if a company’s plan fails the nondiscrimination test? If a plan fails, it may need to restrict contributions or make corrective distributions to ensure fairness.
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Can an HCE still contribute to their 401(k)? Yes, but their limits may be reduced depending on the participation of non-HCEs within the plan.
References and Further Reading
- Internal Revenue Service (IRS): Understanding Highly Compensated Employees
- For a deeper understanding, check out “401(k) Plans: Myths and Facts” by Alan Schmelzerman.
Test Your Knowledge: Highly Compensated Employee Quiz
## What qualifies an employee as a Highly Compensated Employee (HCE)?
- [x] Owning more than 5% of the business or earning over $150,000
- [ ] Only receiving high bonuses with no ownership
- [ ] Retiring early
- [ ] Being the tallest employee of the company
> **Explanation:** As defined by the IRS, an HCE is characterized by significant ownership or high compensation.
## Which of these is a condition for HCEs to face limitations on 401(k) contributions?
- [ ] They work part-time
- [x] Their contribution is limited based on non-HCE participation
- [ ] Every HCE gets to contribute a flat amount
- [ ] Only HCEs that wear glasses face limitations
> **Explanation:** The IRS sets contribution limits for HCEs to ensure a fair distribution of retirement benefits across all employees.
## If you were an HCE in 2023, what was your compensation threshold?
- [ ] $200,000
- [ ] $100,000
- [x] $150,000
- [ ] $175,000
> **Explanation:** The compensation threshold for HCEs in 2023 was $150,000.
## What is a primary purpose of the nondiscrimination test for retirement plans?
- [ ] To entertain tax officials
- [ ] To see who can dance best in the office
- [x] To ensure fair tax advantages for all employees
- [ ] To limit snacks in the break room
> **Explanation:** The nondiscrimination test ensures that all employees benefit equally from the tax advantages of their retirement plans.
## How does owning more than 5% of a business affect HCE classification?
- [ ] Only if they have a great brunch policy
- [ ] It does not affect classification
- [x] It automatically designates them as HCE
- [ ] Only during holiday parties
> **Explanation:** Owning more than 5% of the business qualifies an employee as an HCE, regardless of wages.
## In the context of HCEs, what can the IRS impose limitations on?
- [ ] The type of coffee they can drink
- [x] 401(k) plan contributions
- [ ] Vacation days per year
- [ ] Number of emails sent
> **Explanation:** The IRS imposes limits on HCEs' contributions to ensure that retirement benefits are spread equitably.
## If an HCE is categorized incorrectly, what may happen?
- [ ] They will receive more coffee than others
- [ ] They may get a raise
- [x] Plans may fail nondiscrimination tests
- [ ] They have to wear a goofy hat until corrected
> **Explanation:** Misclassification can lead to issues with plan compliance, affecting fairness in benefit distribution.
## What year does the compensation threshold increase for HCEs?
- [ ] 2025
- [ ] 2026
- [ ] 2023
- [x] 2024
> **Explanation:** The compensation threshold will increase for the year 2024.
## What is the main focus of the IRS when classifying HCEs?
- [ ] Ensuring all parties have free snacks
- [x] Fairness in retirement plan contributions
- [ ] Being the party planner for corporate outings
- [ ] Deciding the office dress code
> **Explanation:** The IRS ensures that retirement funds are equally distributed without favoritism towards highly compensated individuals.
## Why don’t we hear much from HCEs during meetings?
- [ ] They are too busy to attend
- [ ] They hold back to let others shine
- [x] They're trying to figure out if they qualify for discounts
- [ ] They prefer teleconferences with their pet cats
> **Explanation:** HCEs often have their hands in the workplace, juggling many obligations, including interpreting IRS rules!
Thank you for exploring the captivating world of Highly Compensated Employees! 😄 Remember, when in doubt about financial matters, just consult your accountant or enjoy a good joke about taxes—they’re often the best “write-off”!
