Highly Compensated Employee (HCE)

Classification of Highly Compensated Employees

For employees to be classified as a Highly Compensated Employee (HCE), they need to meet certain qualifications set by the Internal Revenue Service (IRS):

• They own 5% or more of the company regardless of their compensation. Ownership applies to spouses, children, and grandchildren working under a single company.
• Their annual earning will be more than $150,000 in 2023. Compensation covers all income an employee receives from the company, including bonuses, commissions, and other types of incentive pay.

• When ranked according to their compensation, they are in the top 20% of employees, and the employer has chosen to classify them as an HCE.

What is a 401(k) Plan?

This plan is a retirement savings plan that allows employees to save for retirement with pre-tax dollars.

With this savings vehicle, the employee's contribution is deducted from their paycheck before federal taxes are applied. These contributions and earnings grow tax-deferred until the money is withdrawn from the account, usually at retirement.

Employers can match some percentage of the employee's contribution up to a limit each year. Often, this match is "on the dollar," meaning that the employer matches what you put in up to a certain amount. Some companies offer a 50% match on your first 6% of contributions each year.

Sustainable 401(k) plans are growing in popularity as employers demand 401(k) investment options that align with the company and employees' values. Use a 401(k) comparison tool to understand which provider will offer your company the best portfolio options, level of service, and value.

401(k) Contribution Limits for HCEs

The 401(k) contribution limit for 2023 is $22,500 or $30,000  if you are 50 or older. The amount HCEs can contribute depends on how much the company's non-HCEs contribute to their accounts.

A company's annual nondiscrimination test, which separates employees into non-highly compensated and highly compensated employees (HCE), must ensure that HCE average contributions are not more than 2% higher than the average contributions of non-HCEs.

Total HCE contributions also can not be more than double the total contributions of non-HCEs.

If a 401(k) fails the nondiscrimination test, the company must take immediate steps to correct the issue, or the plan could lose its tax-qualified status.

The company can fix it by making extra contributions to the non-HCE's  401(k)s or requiring HCEs to withdraw some of their contributions.

Benefits of HCEs Investing in 401(k) Plan

One of the benefits of HCE investing in 401(k) plans besides tax-deferred growth is that they can put away more money than non-HCEs.

For example, if a company offers a match on your contributions and lets you contribute pre-tax dollars, this will help lower your taxable income for the year.

That means you will potentially pay less in taxes on your salary, leading to greater take-home pay. Getting the exact amount that is withheld may help you avoid an underpayment penalty.

If an underpayment penalty is levied against your account and you are able to figure out how much was withheld incorrectly, you can request the company send a corrected W-2 Form to the withholding agent.

HCEs Should Avoid Exceeding 401(k) Contribution Limits

Evaluate your choices carefully regarding investment options for your 401(k). You want to balance outgrowth and safety, and the last thing you want is to invest too much in high-risk investments and be liable for an early distribution penalty if you change jobs.

You can set yourself up on an automatic withdrawal program, which will withdraw a fixed amount from your paycheck every pay period and deposit it into your 401(k) account. You will not need to worry about making a contribution decision every pay period.

Another way to ensure that you do not exceed the 401(k) contribution limits for HCEs is to use a retirement calculator. This is the best way to figure out how much you can invest in your 401(k).

If you choose not to use a calculator, determine what percentage of your salary you are comfortable investing in your 401(k).

Penalties for Exceeding 401k Contribution Limits for HCEs

One of the penalties for exceeding the 401(k) contribution limits for HCEs is an excise tax on your excess contributions, called unqualified or improperly contributed plan assets.

The money that is withheld from your account comes out immediately, but it is not considered taxable income. That makes it even more important to make sure the money withdrawn is invested in your company's plan.

Excess contributions can be distributed back to you without incurring a penalty, but you are still subject to withholding taxes on the amount that was incorrectly deposited into your account.

The excess contribution rules also apply when you take a loan from your 401(k) plan, which may be more dangerous if you are close to the 401(k) contribution limits for HCEs.

Other Retirement Vehicles HCEs Can Consider

If HCEs want to contribute more than these limits due to company matching contributions or other incentives included in their 401(k) plan, there are five options which include:

Contributing to a Roth IRA

Roth IRAs allow contributions for those earning up to $153,000 for single filers or $228,000 for those who are married filing jointly. These limits are applicable for the year 2023.

Roth IRAs at least five years old will allow eligible withdrawals to be tax-free during retirement.

Contributing to a Non-deductible Traditional IRA

Since traditional IRAs prohibit tax-deductible contributions if an employee's income reaches more than $83,000 for single filers or $136,000 if married filing jointly for the year 2023, HCEs may contribute to a traditional IRA with pre-tax dollars instead.

Making Backdoor Roth IRA Contributions

This option requires an HCE to first contribute to a non-deductible traditional IRA followed by converting the account into a Roth IRA.

Opening a Health Savings Account (HSA)

Although this is an employer-sponsored benefit, employees can contribute money to their accounts through pre-tax payroll deductions as long as they meet certain requirements.

Going for a Taxable Brokerage Account

Investing in a taxable brokerage account will make employees owe taxes on their contributions.

However, there are no contribution limits to restrict them and the earnings will be subject to long-term capital gains tax rather than income tax, which saves them money.

Key Takeaways

HCEs can maximize their retirement contributions by considering all available options, including 401(k) plan limits and traditional IRA conversions.

There are a few key points to keep in mind if you are a highly compensated employee who wants to contribute more than the 401(k) contribution limits for HCEs.

The only option that does not subject the money to income tax is investing in a taxable brokerage account.

The other options allow your money to grow tax-free, but you will be liable for income taxes.

They should also carefully consider the pros and cons of each option to ensure that they get more savings on their subsequent tax filing.

If you are an HCE who does not want to worry about exceeding the 401(k) contribution limits for HCEs, then having more than one retirement vehicle can help relieve some of that stress.

FAQs

1. Who is considered as HCEs?

According to the IRS, a highly compensated employee (HCE) is defined as someone who receives compensation amounting to $150,000 for the year 2023 or owns more than 5% of the company regardless of compensation.

2. What is the 401(k) contribution limit for 2023?

For 2023, the 401(k) contribution limit is set at $22,500 or an additional $7,500 as catch-up contributions for those who are at least 50 years of age.

3. What is the use of a nondiscrimination test?

The goal of the nondiscrimination test is to make sure that HCEs and non-HCEs contribute a fair amount. This ensures that the contributions do not favor one group, specifically HCEs, over another, potentially leading to tax fraud.

4. What options are available to HCEs who want to contribute more than the 401(k) limit of highly compensated employees?

First, HCEs can contribute to their Roth IRA accounts. Second, they can invest in a non-deductible traditional IRA and convert it into a Roth IRA. They can also consider making backdoor Roth contributions or opening a Health Savings Account.

5. What does compensation mean in the rules set by the IRS in defining who the HCEs are?

According to the IRS, compensation means wages and earnings from self-employment. It may also mean commissions, taxable alimony, separate maintenance payments, taxable unemployment compensation benefits, and some tips.