What is a highly compensated employee? Definition, rules, and thresholds

Running a compliant retirement plan is one of the most important responsibilities for any employer. But if your company sponsors a 401(k) plan or another qualified retirement plan, there’s a special category of employee you need to understand: the highly compensated employee (HCE).

For small and mid-sized businesses, navigating the rules around HCEs can feel complex. The definitions involve IRS salary thresholds, ownership tests, and nondiscrimination requirements that directly impact how much certain employees can contribute to retirement plans. And missteps can put your plan out of compliance with the Department of Labor (DoL) or the Internal Revenue Service (IRS), leading to penalties and costly corrections.

In this guide, we'll break down the confusion and explain everything you need to know about highly compensated employees, including definitions, compliance tests, and strategies for keeping your plan fair and compliant. So let's jump straight in.

Who is a highly compensated employee?

The IRS defines highly compensated employees (HCEs) as either:

1. An employee whose total annual compensation exceeded a set threshold in the previous plan year, under the compensation test.
2. Anyone who owns more than 5% of the business (in the current or previous plan year), regardless of their salary. This is assessed under the ownership test.

What is the compensation test?

Under the compensation test, the current IRS salary threshold for the previous plan year is $155,000, although this figure is adjusted annually. For instance, if your employee earned above this amount last year, they are considered an HCE.

As mentioned, this includes the employee's total annual compensation, which means wages, bonuses, commissions, overtime pay, taxable fringe benefits, and some equity incentives.

Note that, as the employer, you can apply a top-paid group election, which restricts HCE status to the top 20% of your company's earners.

What is the ownership test?

The ownership test applies regardless of how much the individual earns in salary, and ownership attribution can extend to family members and related companies in a Controlled Group or Affiliated Service Group.

Why does the IRS care about highly compensated employees?

The IRS requires retirement plans to be fair, and to not disproportionately favor executives or higher earners. To enforce this, your retirement plans must pass nondiscrimination tests (see below), ensuring contributions for HCEs are balanced against those of non-HCEs.

This prevents a situation where executives max out their 401(k) contributions, while rank-and-file employees receive little or no benefit.

How do you comply with 401(k) plan rules for HCEs?

When administering a 401(k) plan (or other qualified retirement plan), there are several annual nondiscrimination tests that help ensure your plan is compliant in regard to HCEs. These are:

1. The ADP test

The Actual Deferral Percentage test (or ADP test) measures whether your 401(k) plan disproportionately favors HCEs when it comes to elective deferrals (i.e., the salary percentage that your employees choose to contribute to the plan).

It compares the average deferral rates of HCEs against those of non-HCEs, with strict limits on how much higher the HCE average can be. If the gap is too wide, the plan fails the test, and you must take corrective action (usually by refunding contributions to HCEs or making additional contributions to non-HCEs).

What is the current ADP test?

• If the non-HCE average is 0-2%, the HCE average can be up to 2 percentage points higher.
• If the non-HCE average is 2-8%, the HCE average can be up to 2x that rate.
• If the non-HCE average is above 8%, the HCE average can be no more than 1.25x that rate.

This is particularly important if your company has a low headcount, as the smaller your company, the easier it is for one or two people to skew the numbers.

For example, at a 10-person startup, if two co-founders each max out their 401(k) and no one else contributes, your company will likely fail the ADP test.

2. The ACP test

The Actual Contribution Percentage test (or ACP test) is similar to the ADP test, but focuses on employer-matching contributions and employee after-tax contributions instead of elective deferrals. It compares the average contribution rates of HCEs and non-HCEs to ensure that benefits are distributed fairly.

Failing this test can also trigger corrective measures, such as refunding contributions to HCEs or providing additional contributions to non-HCEs. Because it deals with the employer match, the ACP test is particularly important for companies that use matching formulas as part of their retirement plan design.

3. The top-heavy test

The top-heavy test looks at the distribution of total plan assets to determine whether key employees (i.e., business owners, officers, and HCEs) hold more than 60% of the plan’s assets. If the plan is deemed top-heavy, the employer is required to make minimum contributions for all eligible non-key employees, regardless of whether they contribute themselves.

This test is especially relevant for small businesses where ownership interests and compensation may be concentrated among a few individuals. Complying with the top-heavy test is essential to prevent a retirement plan from becoming overly skewed in favor of executives and owners.

What is the difference between HCEs and key employees?

As explained, HCEs are defined by income level or ownership stake and are used to determine who is included in 401(k) nondiscrimination testing.

Key employees, on the other hand, are identified for the top-heavy test and typically include business owners, officers earning above a set salary level, or anyone with significant ownership. While there can be overlap, not all HCEs are key employees, and the two categories serve different compliance purposes.

What are some common mistakes employers make with HCEs?

Even well-managed companies can stumble when it comes to HCE rules. Here are some of the most frequent challenges employers face:

1. Overlooking related companies

As touched on, businesses that are part of a Controlled Group or Affiliated Service Group must consider ownership across all entities when applying the ownership test. However, many employers evaluate each company separately, which can lead to undercounting HCEs and failing nondiscrimination tests.

For small and mid-sized businesses with multiple related entities, this is a frequent source of compliance issues.

2. Not updating salary thresholds

The IRS regularly adjusts the salary threshold for identifying HCEs. And if you rely on outdated figures, you risk misclassifying employees.

This not only causes errors in nondiscrimination testing but can also result in corrective distributions that frustrate employees who thought they were contributing within the rules.

3. Confusing HCE rules with overtime exemptions

Employers sometimes conflate the IRS definition of a HCE with the DoL’s “highly compensated” exemption under the Fair Labor Standards Act (FLSA).

But while the terms sound similar, they serve entirely different purposes. The former applies to retirement plan compliance, while the latter determines whether employees are exempt from overtime pay. Mixing them up can lead to compliance problems on both fronts.

4. Improper corrective actions

As mentioned, failing an ADP test, ACP test, or top-heavy test requires timely corrections (such as issuing refunds to HCEs or making additional contributions for non-HCEs).

One particularly common pitfall is delaying or miscalculating these corrections, which can put the plan at risk of disqualification. Working closely with a third-party administrator or a plan provider can help avoid these costly mistakes.

5. Neglecting mid-year testing

Some employers wait until the end of the plan year to check compliance, only to discover problems that are much harder to fix retroactively.

Running mid-year “test runs” can identify issues early and give businesses more time to adjust contributions or consider other options, like adopting a Safe Harbor 401(k) plan (see below).

6. Failing to communicate with employees

When a plan fails a nondiscrimination test and you're forced to refund contributions to your HCEs, they often feel penalized or confused.

Employers who don’t clearly explain the rules may face employee dissatisfaction or reduced participation in the plan, whereas transparent communication helps maintain trust and encourages ongoing contributions.

How can a Safe Harbor 401(k) plan help?

Even if your company is committed to offering strong benefits, it can still fail the ADP test or ACP test if non-HCE participation is low. This is a huge source of frustration for many businesses.

Which is where a Safe Harbor 401(k) plan comes in. This plan is designed to automatically satisfy the IRS’s nondiscrimination requirements; in exchange, you (the employer) make a guaranteed contribution to your employees’ accounts each year.

Once those contributions are made, the plan is deemed compliant, and HCEs can defer the maximum allowed amount without the risk of refunds or corrective actions.

To qualify for a Safe Harbor plan, you must commit to one of several contribution formulas such as basic matching, enhanced matching, or nonelective contribution.

Important: While Safe Harbor plans can reduce compliance headaches, they require careful budgeting. Employer contributions are mandatory each year, so your business must be ready to make that financial commitment regardless of company performance.

Some employers address this by aligning Safe Harbor contributions with other strategic goals, such as employee retention or talent attraction, to make the expense more sustainable.

What are the current 401(k) contribution limits?

Here are the IRS-set 401(k) contribution limits for both HCEs and non-HCEs in 2025:

Employee elective deferrals:

Employees can contribute up to $23,000 of their salary into a 401(k) plan in 2025. Those aged 50 and older can make an additional catch-up contribution of $7,500, bringing their total possible deferral to $30,500.

Employer contributions:

Employers can add matching or nonelective contributions on top of employee deferrals. However, the combined total of employee and employer contributions cannot exceed the annual limit of $69,000 (or $76,500 with catch-up contributions for employees aged 50 or over).

Compensation limits:

When calculating contributions, only the first $345,000 of an employee’s annual compensation can be considered. Any pay above this cap does not count toward contribution calculations.

What to do if you’re audited

If you’re ever audited by the IRS or the DoL, one of the things you may be asked to produce is your HCE documentation. Make sure you can show:

• How your HCEs were identified
• How testing was performed
• Any corrective actions taken

Having your records in order (and stored digitally) can make this process significantly quicker and easier.

How can Remote help?

Your highly compensated employees might only make up a small part of your team, but their impact on your 401(k) plan can be massive. Getting their classification right — and understanding what it means for contributions and compliance — protects your benefits strategy and keeps your team happy.

With Remote’s automated payroll software, you can automatically track compensation thresholds, calculate benefits costs, and ensure you have access to accurate, real-time records. This helps ensure that you stay compliant, and significantly reduces manual work.

To learn more or to see how it works, speak to one of our friendly experts today.