What Is a Highly Compensated Employee?

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DEFINITION

A highly compensated employee is one who either owns more than 5% of the company they work for or earns total annual compensation of $135,000 or more from the company, an amount that is adjusted periodically for inflation.

Definition and Example of a Highly Compensated Employee

According to the IRA, a highly compensated employee (HCE) is an employee who meets one of these two criteria:

  1. Owns at least 5% of the company, regardless of whether the company is public or private.
  2. Earned more than $135,000 in 2022 or $130,000 in 2021 or 2020. And, if the employer elects, was among the top 20% of earners at the company.
  • Acronym: HCE

For example, if an employee has a base salary of $120,000 and also receives a bonus of $20,000, then their total annual compensation would be $140,000. Therefore, they would be considered a highly compensated employee.

In addition, someone who owns 7% of the company would also be considered an HCE—even if their salary was just $30,000 a year.

How Does a Highly Compensated Employee Work?

Being classified as a “highly compensated employee” is a tax status used by the Internal Revenue Service (IRS). It has nothing to do with how financially stable someone is, or how well they feel they are being paid.

There are two ways the IRS determines your HCE status: an ownership test and a compensation test.

Ownership Test

If you (or someone in your immediate family) own at least 5% of the company, you’re considered a highly compensated employee. According to the IRS’ family attribution rules, if your spouse, child, grandparent, or parent owns at least 5% of that company, you’re considered an HCE by default.

It doesn’t matter how much money you make—whether it’s $20,000 or $2,000,000—you’re considered an HCE if you or a family member is at least a 5% owner.

Simply owning more than 5% of a company doesn’t make you an HCE. You must actually work for that company.

Compensation Test

You can also qualify as a highly compensated employee based on your compensation. If you own less than 5% of the company, you would only be considered an HCE if you made at least $135,000 in total compensation in 2022 or $130,000 if it’s for 2021 or 2020. The IRS adjusts its HCE limits along with inflation.

A salary of $135,000 is considered a high salary in some areas. But if you live in major cities such as New York or San Francisco, you may still feel like you’re living from paycheck to paycheck even if you earn enough to qualify as an HCE.

What It Means for Individual Investors

The IRS has defined a highly compensated employee for a specific reason. This classification helps determine tax advantages.

The IRS classifies employees as either HCEs (highly compensated employees) or NHCEs (non-highly compensated employees). It then performs tests on a company’s benefits—such as its 401(k) plan and flexible spending account—to ensure HCE contributions don’t exceed NHCE contributions by more than 2%.

If an employer is found to be noncompliant, the company’s benefits could lose their tax-exempt status, which would put employee contributions in jeopardy. So it’s in a company’s best interest to stay compliant and non-discriminatory.

If you’re not sure if you qualify as an HCE, contact your human resource department, which can tell you how much you can contribute to your 401(k).

Drawbacks of a Highly Compensated Employee

While highly compensated employees may enjoy larger salaries or company ownership, being a highly compensated employee has a few drawbacks. For one, HCEs may have stricter limitations on what percentage of their salary they can contribute.

The IRS conducts nondiscrimination tests for companies’ 401(k) plans called Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP). Essentially, it wants to ensure 401(k) contributions made by average employees and highly compensated employees are proportional.

Identifying which employees are HCEs and which are NHEs is an important component of these tests.

If you’re an HCE and your employer fails its IRS discrimination test, your overcontributions will get recategorized as taxable income for the year, and you may be charged penalties by the IRS.

Retirement Savings Options for Highly Compensated Employees

If you can’t contribute as much to your 401(k) as you’d like , you have a few other ways to save for a comfortable retirement.

IRAs

Anyone can contribute to a traditional IRA as long as they have earned income. The contribution limit for both traditional and Roth IRAs is $6,000 for 2022. If you’re 50 or older, you can contribute $7,000.

Keep in mind there are income limits for how much you can contribute to a Roth IRA. For 2022, you cannot have a modified adjusted gross income (MAGI) of more than $144,000 for individuals or $204,000 if you’re married and filing jointly.

Health Savings Accounts (HSA)

A health savings account (HSA) is a triple tax-advantaged account, meaning your contributions are tax-deductible, your investment growth is tax-deferred, and withdrawals for qualified medical expenses are tax-free.

If you have a high-deductible health plan (HDHP), you’re eligible to open and contribute to an HSA. For 2022, you can contribute up to $3,650 as an individual or $7,300 as a family. If you’re 55 or older, you can also make a catch-up contribution of $1,000.

Backdoor Roth IRA Strategy

A backdoor Roth IRA is a good option for HCEs who earn too much to qualify for a Roth IRA.

Here’s how it works:

  • You contribute to a traditional IRA (there are no income limits for traditional IRAs). 
  • You convert your traditional IRA contribution into a Roth IRA. 
  • You pay taxes on the amount you convert, but enjoy tax-free growth and withdrawals in retirement.

Save in a Taxable Brokerage Account

A taxable brokerage account is an investment account where you don’t get the tax benefits of a retirement account, but you also don’t have contribution limits. You can invest in stocks, bonds, ETFs, and mutual funds in a taxable account. And if you hold your investments for at least a year, you’ll qualify for the long-term capital gains tax rate, which is lower than your income-tax rate.

Other Benefits

Some companies give HCEs access to non-qualified retirement plans such as supplemental executive retirement plans (SERPs) as an additional way to save for retirement.

Your employer may also have access to stock options or other benefits that could help you boost your savings.

Consider meeting with a financial advisor to see what other retirement planning options may be available to you.

Key Takeaways

  • A highly compensated employee (HCE) is defined by the IRS.
  • An HCE may be someone who owns more than 5% of the company they work for.
  • You may be an HCE if you made more than the IRS limit, which is $135,000 a year for 2022.
  • If you’re a highly compensated employee, there may be stricter limits to how much you can save in your 401(k).


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