Highly Compensated Employee (HCE)

Highly Compensated Employee (HCE) in the context of employer-sponsored 401(k) plans refers to an individual who falls under a specific income threshold set by the Internal Revenue Service (IRS). This designation is crucial in administering retirement plans, as it determines the level of contribution limits and compliance testing required to maintain the plan's tax-qualified status.

To be considered an HCE, an employee must meet one of the following criteria:

• The employee received more than a certain compensation threshold (e.g., $130,000 in a year), adjusting annually for inflation.

• The employee is a 5% owner of the company at any time during the current or preceding year.

• The employee belongs to the top-paid 20% of all employees in the company.

HCE status can impact the 401(k) plan in several ways. One significant effect is the annual ADP (Actual Deferral Percentage) and ACP (Actual Contribution Percentage) tests. These tests ensure that contributions made by HCEs are not disproportionately higher than those of non-HCEs, avoiding potential discrimination issues.

Failure to pass these compliance tests can lead to corrective measures, such as returning excess contributions to HCEs or making additional contributions to non-HCEs. Employers must monitor HCE status and adjust contributions accordingly to maintain the 401(k) plan's tax-favored status and benefits for all employees.

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