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Can an employee ever make too much money? The IRS may think so and put some constraints on them. To learn more about these constraints, and what it means to be considered a highly compensated employee, read on.

Who Are Highly Compensated Employees?

Highly compensated employee (HCE) is a classification that the Internal Revenue Service (IRS) uses to monitor company compliance around 401(k) contributions. HCEs may be restricted from making the maximum contributions to their work retirement savings accounts (401(k)) based on their earnings or ownership in the company relative to the balance of non-HCE employees’ contributions to their 401(k)s.

How Does a Highly Compensated Employee Work?

To earn the HCE designation, an employee must meet one of the following two tests:

Ownership Test

If an employee, or someone in their immediate family, owns at least 5% of the company, they are considered highly compensated by the IRS.

Compensation Test

Salary can also be used to classify HCEs. In 2022, employees earning $135,000 or more per year (including bonuses or other incentives) are considered HCEs. It’s important to note that this is not how one feels about their salary but rather the guidelines put forth by the IRS. Salary guidelines are adjusted annually for inflation. For 2021, the HCE guideline was $130,000.

Other Information to Know

Note that in either test, an employee must actually work for the company to be considered an HCE. Also note that the IRS defines immediate family as parent, spouse, grandparent or child. Should an employee become an HCE at any point during the year, they will be held to the contribution restrictions set forth by the IRS for the tax year in which they became an HCE.

How Do Highly Compensated Employee Rules Affect Employers?

The following rules were established to create a balance between HCE and non-HCE retirement savings contributions which employers are held responsible for managing. Employers can be affected in the following ways:

  • ERISA. This set of regulations, ERISA, was put into effect in 1974 to ensure employers act as proper fiduciaries of qualified pension and welfare benefit plans. Qualified plans are employee-sponsored and thus have tax benefits.
  • Form 5500. This is an IRS-mandated form that employers must electronically file annually to ensure through disclosure that the terms of the retirement savings plan are compliant with IRS regulations. Click here Form 5500 IRS for further definitions and instructions.
  • The 2% rule. The total dollar amount of HCEs’ contributions cannot exceed the aggregate dollar amount of non-HCEs by more than 2%. This rule ensures that the balance of overall contributions is fairly equal between both classes of employees.
  • Overcontribution. When a company finds that its contributions are in violation of the 2% rule, it must reclassify any over-contributions as ordinary income back to the impacted HCEs.

Drawbacks of Highly Compensated Employees

Making significant income can be somewhat of a double-edged sword. Here are a few of the pain points HCEs must grapple with:

Contribution Limitations

Forced limitations on the amount HCEs can contribute to retirement savings accounts can negatively impact their ability to save at their desired rate, and can also cause them to miss out on company contribution matching plans, thus becoming a double negative.

Overcontribution Reclassification

Being unable to contribute the full amount to retirement savings plans can shift HCEs into higher tax brackets inadvertently.

Flight Risk

The engagement and productivity of HCEs, who are typically the employees that create strategy and lead the company, can be at risk if they feel that the income they earn cannot be preserved through the company’s benefits offerings. Senior level turnover, and with it the loss of intellectual capital, could become a risk over time.

Other Accounts That Highly Compensated Employees Can Consider

HCEs need ways to defer income to mitigate the impact of 401(k) contribution restrictions. Here are a few strategies to consider.

Traditional Brokerage IRA

HCEs can deposit the difference between the maximum allowed by the IRS and the amount allowed by their employer into a traditional IRA, sometimes referred to as a “self-directed” IRA. These accounts may have been established under previous employment or rolled over to a brokerage account, hence the term self-directed.

Health Savings Accounts (HSA)

For employees who have the option of electing a high-deductible health plan (HDHP), a companion HSA is available. Automatic payroll withdrawals can be set up to fund this account with pre-tax dollars that are tax-deferred until they are used. The IRS imposes an annual limit for individual and family contributions, and adjusts the amount for inflation, often annually. 2022 HSA limits. Aside from tax benefits, HSA accounts are fully portable. In contrast to flexible spending accounts (FSA), that money belongs to the employee even after they leave their employer. Like FSAs, the money can only be used to pay for qualified medical expenses. HSAs can be a terrific way to save for medical expenses while getting the tax benefit. HSA facts.

Back Door Roth IRA

This strategy is tricky and should be used in partnership with a financial advisor. Contributions into Roth IRAs are after-tax dollars, so there is no tax-deferral benefit for the given tax year. The benefit of the Roth IRA is if the HCE anticipates earning higher levels in the following tax years and may be in a higher tax bracket. Unlike traditional IRAs, withdrawals on Roth IRAs (after you reach age 59 ½) are penalty-free and tax-free. Therefore, paying taxes upfront on Roth contributions can save you from paying taxes on future withdrawals when you may be in a higher tax bracket. Note that the total of all contributions to all retirement saving accounts cannot exceed the maximum allowed by the IRS for any given tax year. Contributing the maximum to both the traditional and Roth IRAis not permitted. Back Door Roth IRA.

Traditional Brokerage Account

While not a tax deferral strategy, traditional brokerage accounts offer HCEs a strategy around overall cash management and investment strategy. Excess cash earned can be invested in accordance with age, risk tolerance and other investment goals that can effectively complement retirement savings accounts. Gains from investments held in excess of one year are subject to long-term capital gains tax rates which are currently 20%, typically lower than income tax rates.

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Questions You’ve Asked Us About Highly Compensated Employees

It depends. No more than 2% over the average contribution rate of non-HCEs. If non-HCEs’ average contribution rate is 4%, then the maximum contribution rate would be 6% for the HCE population. That would be $9,000 for an employee earning $150,000.
Key employee, along with HCE, is another classification that the IRS uses to ensure a pension or welfare benefit plan isn’t becoming too “top-heavy.” A key employee is an HCE with slightly higher thresholds. Key Emp Definition 2022(https://www.dwc401k.com/knowledge-center/who-are-highly-compensated-and-key-employees) defines the thresholds, which are adjusted for inflation annually.

Milly Christmann is a high energy, operationally oriented talent management leader with extensive expertise in human resources, sales management, service and operations. She is recognized for collaborating with leaders to achieve their business goals by unleashing the power of an engaged workforce. By using process improvement, technology and strong, impassioned people skills as well as by attracting, developing and retaining top talent, Ms. Christmann drives change that matters.

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