Highly Compensated Employee (HCE)

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on February 15, 2024

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What Is a Highly Compensated Employee (HCE)?

An HCE is an employee who meets certain income and ownership criteria set forth by the Internal Revenue Service (IRS) in the United States.

HCEs are typically executives, managers, or other highly skilled or specialized employees who earn a higher income than other employees within their company.

To be classified as an HCE, an employee must earn a certain level of compensation and/or own a certain percentage of the company.

These requirements are set annually by the IRS and are designed to ensure that HCEs do not receive disproportionately large benefits under company retirement plans.

Eligibility Requirements for HCEs

To be considered an HCE, an employee must meet certain eligibility requirements, which include the following:

Annual Compensation Threshold for HCEs

The IRS sets an annual compensation threshold for HCEs, which is adjusted for inflation each year. This threshold is based on the employee's compensation from the previous year.

For example, in 2024, an employee must have earned at least $150,000 in 2023 to be considered an HCE for 2024. For plan year 2025, an employee’s 2024 salary must be at least $155,000 to be eligible as an HCE.

Ownership Stake Requirements for HCEs

An employee can also qualify as an HCE if they own more than 5% of the company. This means that if an employee owns more than 5% of the company, regardless of their income, they would be considered an HCE.

This requirement is designed to ensure that employees with significant ownership stakes in the company are not disproportionately benefiting from the company's retirement plans.

Definition of Family Members for HCEs

When determining ownership stakes for HCEs, the IRS also considers the ownership of family members. This means that if an HCE's spouse, children, or other family members own shares in the company, those shares will be attributed to the HCE.

For example, if an HCE's spouse owns 10% of the company, the HCE would be considered to own 15% (their own 5% ownership stake plus their spouse's 10% ownership stake).

Advantages of Being Classified as HCE

The benefits can vary depending on the company and the specific position, but some of the most common benefits include:

Higher Salary

HCEs typically earn a higher salary than other employees within the company. This can be due to their specialized skills, extensive experience, or significant contributions to the company.

Better Benefits

HCEs may also receive better benefits, such as more generous retirement plans, health insurance, and other perks. These benefits may be more valuable or have higher contribution limits than those available to other employees.

Advancement Opportunities

HCEs may have greater opportunities for career advancement within the company. This can include access to leadership or management roles, as well as opportunities to work on high-profile projects or initiatives.

Recognition and Prestige

Being classified as an HCE can also come with a certain level of recognition and prestige within the company. HCEs may be seen as valuable contributors to the company's success and may receive more public recognition or rewards for their work.

Disadvantages of Being Classified as HCE

While being classified as a Highly Compensated Employee can come with certain benefits, there are also challenges and drawbacks that HCEs may face. Some of these challenges include:

Increased Tax Liability

HCEs may be subject to higher tax rates than other employees due to their higher income. This can result in a higher tax burden and lower take-home pay.

Discrimination Risks

Because HCEs typically earn a higher salary and receive better benefits than other employees, there is a risk that they may be seen as privileged or favored within the company.

This can lead to resentment or discrimination from other employees, which can be difficult for HCEs to navigate.

Retirement Plan Limits

HCEs may be subject to lower contribution limits for retirement plans than other employees. This is because retirement plans, like 401(k), must pass nondiscrimination tests to ensure that they are not disproportionately benefiting HCEs.

If the plan fails these tests, HCEs may be required to return some of their contributions or face other penalties.

Compliance Requirements

Companies with HCEs must comply with certain requirements, such as nondiscrimination testing for retirement plans and reporting and disclosure requirements for HCE compensation. This can be time-consuming and costly for the company.

Advantages and Disadvantages of Being Classified as a Highly Compensated Employee (HCE)

HCEs and Retirement Plans

Retirement plans are an important benefit for many employees, and HCEs play a unique role in these plans. Here are some key considerations regarding HCEs and retirement plans:

Role of HCEs in Company Retirement Plans

HCEs may be eligible to participate in the company's retirement plan, just like other employees. However, because HCEs typically earn a higher income than other employees, they may be subject to different contribution limits and other rules.

Limits on Contributions for HCEs

Retirement plans must pass certain nondiscrimination tests to ensure that they are not disproportionately benefiting HCEs.

One of these tests is the "actual deferral percentage" (ADP) test, which limits the amount of contributions that HCEs can make to the plan. If the plan fails this test, HCEs may be required to return some of their contributions or face other penalties.

Consequences for Plans That Discriminate in Favor of HCEs

If a retirement plan is found to discriminate in favor of HCEs, there can be serious consequences for the company.

For example, the plan may lose its tax-qualified status, which can result in significant tax penalties for both the company and the employees. In addition, employees may be required to return some of their contributions or face other penalties.

Final Thoughts

HCEs are employees who meet specific income and ownership criteria set by the IRS in the United States. Being classified as an HCE can come with advantages such as higher salaries, better benefits, and more advancement opportunities.

However, there are also challenges and drawbacks such as increased tax liability, discrimination risks, retirement plan limits, and compliance requirements.

For companies, there are requirements such as nondiscrimination testing for retirement plans and reporting and disclosure requirements for HCE compensation. HCEs play a unique role in retirement plans, and they may be subject to different contribution limits and rules.

The consequences for plans that discriminate in favor of HCEs can be severe, including the loss of tax-qualified status and significant penalties.

Overall, HCEs have an important role in companies and retirement plans, but it is essential to navigate the associated challenges and requirements carefully.

Highly Compensated Employee (HCE) FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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