Defining Highly Compensated Employees (HCEs) According to the IRS
As defined by the IRS, an employee qualifies as a Highly Compensated Employee if they satisfy one of the following criteria:
- Ownership test: The person held more than 5% ownership in the company at any time during the current or previous year, regardless of their earnings.
- Compensation test: They earned over $155,000 in the previous tax year (2024) or over $160,000 (2025), and fall within the top 20% of employee earners.
Why Distinguish Highly Compensated Employees?
Separating HCEs from other employees promotes fairness in retirement benefit distribution. This IRS regulation ensures that the tax advantages of 401(k) plans are not disproportionately skewed toward higher-earning workers.
HCEs and 401(k) Contributions in 2024–2025
2024 contribution limits: $23,000 for those under 50; $30,500 for participants aged 50 or older.
- 2025 limits: $23,500 for under-50s; $31,000 for ages 50–59 or 64+; and $34,750 for ages 60–63.
However, HCEs may not be able to contribute the full amount if non-HCEs in the company contribute less, due to nondiscrimination rules.
Who Is an HCE in 2025?
In 2025, the IRS designates anyone earning over $160,000, and ranking among the top 20% of employees by compensation, as highly compensated. This is up from the $155,000 threshold in 2024. The term “compensation” includes not just wages, but also overtime, bonuses, commissions, and any salary deferrals such as 401(k) contributions.
Nondiscrimination Testing for HCEs
Employers must run annual nondiscrimination tests to ensure fairness:
- The average contribution rate of HCEs cannot exceed that of non-HCEs by more than two percentage points.
- Total contributions from HCEs cannot exceed double those of non-HCEs.
If a plan fails, the employer has two options:
- Increase contributions for non-HCEs, or
- Request that HCEs withdraw some of their 401(k) contributions.
For example, if non-HCEs average a 5% contribution rate, HCEs cannot exceed 7% or the plan fails the test.
Alternative Saving Strategies for HCEs
If nondiscrimination testing limits 401(k) contributions, HCEs can still maximize retirement savings through:
- After-tax contributions to an IRA
- Backdoor Roth IRAs
- Health Savings Accounts (HSAs)
- Taxable investment accounts
HCE Example Scenario
Consider a small business with 8 employees:
| Name | Role | Compensation | Ownership |
|---|---|---|---|
| Kelly | CEO | $600,000 | — |
| Mark | Executive | $300,000 | — |
| Michelle | Director | $250,000 | — |
| Steven | Manager | $80,000 | 10% |
| 4 others | Staff | ≤ $50,000 | — |
- Kelly, Mark, and Michelle qualify as HCEs (each earning above the IRS thresholds).
- Steven also qualifies via the ownership test (holding > 5% of the company).
- The other four employees are classified as non-HCEs (they meet neither the ownership nor compensation criteria).