The Downside to Being a Highly Compensated Employee
How Being Highly Compensated Can Hinder Retirement Savings
Everyone wants a well-paying job, but you might be surprised to learn that there are some significant downsides to having one if you get classified as a "highly compensated employee."
Just because you're well-paid doesn't mean you'll get the label, because it's actually a tax term. But if you do, here is what you need to understand with regards to what that means, especially if you’re in the middle management phase of your career or have access to employee stock options.
What Is a Highly Compensated Employee?
You might think that the term is generic for those people in high places that you can only see by appointment only, but the term is actually IRS language with a very clear-cut definition—and you don't necessarily need to make an obscene amount of money to get that designation.
First, you’re considered a highly compensated employee (HCE) if you owned more than 5% of the interest in a business at any time during this year or the preceding year. Notice the “more than” part of the rule. This means that if you own exactly 5%—based on your voting power—you are not considered highly compensated. However, stock ownership of 5.01% or more puts you under that umbrella.
Also, 5% includes equity owned by relatives, including your spouse, parents, children, and grandchildren. Grandparents and siblings don’t count. If you owned 3% and your spouse owned 2.01%, you are now highly compensated (3 + 2.01 = 5.01). In this case, it doesn’t matter how much money you made. If the business is relatively new, the owners might not draw a salary or the salary might be very little.
Second, you're highly compensated if the business paid you more than $130,000 in 2020, and if you were in the top 20% of employees when ranked by compensation.
You don’t have to meet both criteria to earn this label—if you’re more than a 5% owner but only earn $30,000 per year, you’re considered highly compensated. This might sound obvious, but it's worth remembering that you have to be an actual employee of the company to be considered an HCE. If you simply own 5.01% or more of the company, but you are not an employee of the company, you cannot be an HCE.
How Does It Affect Me?
The highly compensated employee rules were put in place to protect those who don’t fall into this small subset of people. In the beginning, retirement plans allowed anybody, regardless of income, to contribute a certain percentage of their income regardless of how much they made. People who made a lot of money received huge tax breaks that lower-wage earners did not. This was seen as a form of discrimination, so the IRS created the highly compensated employee rules to make it fair for everybody.
Being a highly compensated employee can be less than ideal from a 401(k) perspective. Each year, the business has to go through some tests to make sure the plan is still non-discriminatory. One of those tests is to look at the average contribution rate of all employees.
If the average is 4%, most HCEs can only contribute 6% because highly compensated employees’ contributions cannot exceed the contributions of non-HCEs by more than 2%. Under this scenario, somebody making $150,000 annually can only contribute $9,000 annually—far less than the $19,500 for 2020 and 2021 that the IRS allows. Some HCEs report only being able to contribute 2% because lower-paid employees contribute so little.
Some workers would love to make a six-figure salary, but others, especially those who live in coastal cities like San Francisco or New York City, would argue that $150,000 represents a middle-class lifestyle and hurts those in middle management who need to save all the money they can for retirement. The upper management employee making $300,000 could still almost max out their contributions at 6% but not the low six-figure earner.
Ways Around the HCE Rule
Your employer has some options with how they structure retirement packages, but outside of that, the best thing to do is to contribute to other retirement vehicles. The easiest solution is to start an IRA and max it out. You can contribute up to $6,000 per year in 2020 and 2021 ($7,000 if you're 50 or older). You could also make catch up contributions if you’re over the age of 50, contribute money into taxable investment accounts, and you can still contribute to your 401(k)—you’ll just lose the tax deduction that comes with a non-Roth 401(k).
Some employers go about it another way: they offer a larger employer match or, if they don’t have one, institute it. For cash-strapped employees trying to make ends meet, the incentive to contribute to the plan may not be high enough without an employer match. Along with better education of the benefits of saving for retirement and/or an employee match, experts say that getting above 50% participation is next to impossible—and that means a lower maximum for highly compensated employees.
United States House of Representatives. "26 USC 318. Constructive Ownership of Stock." Accessed Dec. 5, 2020.
IRS. "Definitions." Accessed Dec. 5, 2020.
IRS. "401(k) Plan Fix-It Guide - The Plan Failed the 401(K) ADP) and ACP Nondiscrimination Tests." Accessed Dec. 5, 2020.
IRS. "Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits." Accessed Dec. 5, 2020.
IRS. "Retirement Topics - IRA Contribution Limits." Accessed Dec. 5, 2020.
IRS. "Retirement Topics - Catch-Up Contributions." Accessed Dec. 5, 2020.