Everyone wants a job that pays well, but you might be surprised to learn that there are some significant downsides to being a "highly compensated employee," or HCE. You would be most likely to feel those downsides when you move to the middle-management phase of your career or have access to employee stock options.
Just because you're well-paid, that doesn't mean you'll get the HCE label. This is a tax term used by the Internal Revenue Service (IRS). But if you are considered an HCE, here is what you need to know.
- Highly compensated employees (HCEs) are those whose immediate family owns more than 5% interest in the business at some point during the current or previous year.
- You also count as an HCE if you were paid more than $130,000 in 2020, and that income put you in the top 20% of earners at the company.
- HCE 401(k) contributions are capped at 2% more than non-HCE contributions.
- HCEs can make up for 401(k) limits by maximizing their IRA contributions.
What Is a Highly Compensated Employee?
You might think that the term is a generic one for executives or people you can only see by appointment, but an HCE isn't just someone with a fancy title who makes a lot of money.
The IRS has a very clear definition of who counts as an HCE. You don't even need to make an obscene amount of money to get that label. There are two ways to be considered highly compensated.
You’re a highly compensated employee if you owned more than 5% of the interest in a business at any time during this year or the year before this one. Notice the “more than” part of the rule. This means that if you own exactly 5%—based on your voting power—you are not labeled highly compensated by the IRS. However, stock ownership of 5.01% or more counts.
The 5% threshold includes equity owned by relatives, who could include your spouse, parents, children, or grandchildren. Grandparents and siblings don’t count.
If you owned 3%, and your spouse owned 2.01%, you are considered highly compensated (3 + 2.01 = 5.01). In that case, it doesn’t matter how much money you made. If the business is new, the owners might not draw a salary, or the compensation might be very little.
Salary and Rank
You're also highly compensated if two things are true:
- You were paid more than $130,000 in 2020 from a single company.
- You were in the top 20% when people at that company are ranked by how much they made.
You don’t have to meet both the ownership and salary criteria to earn the HCE label. If you’re more than a 5% owner but only earn $30,000 per year, you’re considered highly compensated.
You can only be counted as an HCE if you are employed by the company. If you simply own 5.01% or more but are not an employee, you cannot be an HCE.
How Do HCE Rules Affect You?
The highly compensated employee rules were put in place to protect those who don’t fall into this small subset of people. When retirement plans were first starting, they allowed anyone to contribute a certain percentage of their income, no matter how much they made. As a result, people who made a lot of money received huge tax breaks that workers who earned less could not. This was seen as a form of discrimination.
The IRS created the highly compensated employee rules to make both retirement savings and tax breaks fairer for all workers.
How Do These Rules Affect Your 401(k)?
Being a highly compensated employee can be less than ideal when you are putting money in a 401(k). Each year, a business has to go through some tests to make sure their 401(k) plan is still non-discriminatory. One of those tests is to look at the average contribution rate of all its workers. If the average is 4%, most HCEs can only contribute 6%. That's because highly compensated employees’ contributions cannot exceed the contributions of non-HCEs by more than 2%.
If, for instance, the average worker puts $7,000 in their 401(k), someone making $150,000 each year can only put $9,000 in theirs. This is far less than the $19,500 that the IRS allows for 2020 and 2021. Some HCEs report only being able to put 2% in their 401(k)s because lower-paid employees put so little in.
Most workers in most parts of the United States would love to make a six-figure salary. Others, often those who live in coastal cities like San Francisco or New York City, might say that $150,000 allows only a middle-class lifestyle.
The upper manager making $300,000 could still almost maximize their contributions at 6%, but a lower six-figure earner would not be able to. As a result, some argue that HCE rules hurt those in middle management who need to save all the money they can for retirement.
What Are Ways Around the HCE Rule?
Your employer has some options for the ways they can structure retirement packages. Otherwise, the best thing to do is to have other retirement accounts that you put money in. The easiest choice is to start an IRA and max it out. You can add up to $6,000 per year in 2020 and 2021 ($7,000 if you're age 50 or older). You could also make catch-up contributions if you’re over the age of 50 or put money into taxable investment accounts.
Even if you're an HCE, 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 by offering a larger employer match. If they don’t have a match, they might start one if enough workers feel the effects of the HCE rules.
For cash-strapped employees trying to make ends meet, the incentive to add to their 401(k) plan may not be high enough without an employer match.
If you are affected by the HCE rules, you can talk to your employer about how to make saving for retirement more accessible for everyone at your office. You can also talk with a financial advisor. Retirement and tax pros will be able to advise you how to keep saving for the future, even when your 401(k) contributions are limited.