Highly compensated employees: Who are they, and how do they affect your 401(k)?

For employers, running a compliant 401(k) plan isn’t just about providing a great benefit — it’s about understanding how the Internal Revenue Service sees your employees. And as part of this process, you may have come across the term ‘highly compensated employee’ (HCE).

Whether you're managing your first benefit plan or attempting to navigate complex reporting rules, being aware of this designation is essential for staying compliant and avoiding costly surprises during annual testing.

In this article, we’ll break down what a highly compensated employee actually is, why it matters for your company’s retirement plan, and what you can do about it. So let’s jump straight in.

What is a highly compensated employee?

In the context of retirement plans, ‘highly compensated’ is not a subjective term; it’s a legal definition. According to the IRS, an employee is considered highly compensated if they meet one of the following criteria:

• Ownership: They own (or owned) more than 5% of the business at any time during the current or previous year — even if they didn’t earn a high salary.

• Compensation: They earned more than $150,000 in 2023, or $155,000 in 2024 (indexed annually for inflation).

• The top 20% rule (optional): Employers can elect to limit HCEs to the top 20% of earners if doing so is more advantageous during IRS non-discrimination testing (see below).

Employees don’t need to meet all three of these requirements — if they meet just one, they trigger HCE status.

Why does the IRS care about highly compensated employees — and why should you?

In short, because of fairness. The IRS wants to ensure your company’s 401(k) plan doesn’t disproportionately benefit higher earners at the expense of everyone else.

If your HCEs are maxing out their contributions while non-HCEs barely participate, your plan could fail IRS nondiscrimination tests. That’s a problem.

The two main tests are:

1. The ADP test (Actual Deferral Percentage). This compares how much HCEs and non-HCEs contribute, as a percentage of pay.

2. The ACP test (Actual Contribution Percentage): This compares employer matching and other contributions.

If your plan fails these tests, you may have to refund contributions to your HCEs, or make additional contributions to non-HCEs, both of which are time-consuming, expensive, and frustrating for your team.

What are the 401(k) rules for highly compensated employees?

If you have HCEs, the IRS rules can affect your payroll in the following ways:

1. The contribution limits may be lower than you expect

While the IRS allows employees to contribute up to $23,000 in 2024 (plus a $7,500 catch-up for those aged 50 or above), HCEs might not get to contribute that much if your plan fails non-discrimination testing. Contributions could be limited or even partially refunded.

2. Exemptions don't automatically apply

There’s no blanket HCE exemption. HCEs don’t get out of compliance testing; in fact, they’re central to it. However, safe harbor 401(k) plans can automatically satisfy non-discrimination tests if certain conditions are met, which can simplify things.

3. Matching contributions still matter

Even if contributions are limited, employer matches for HCEs may still be allowed depending on your plan’s design. This is a smart lever to pull if you want to retain top talent without breaking compliance.

A note for early-stage startups and small businesses

This is particularly important to understand 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 much, you’re likely looking at a failed ADP test. And that’s before you’ve dealt with any ownership considerations.

As a result, you can’t ignore HCE classifications, even if your company is small.

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How to navigate HCE rules

The good news is that you’ve got options. Here’s how to manage HCE rules and still offer competitive retirement benefits:

1. Consider a safe harbor 401(k) plan

Safe harbor plans bypass most non-discrimination tests by making guaranteed employer contributions (either matching or non-elective). If your team has several HCEs, this could save you a compliance headache further down the line.

2. Boost participation with better education

The more your non-HCEs contribute, the easier it is to pass ADP and ACP tests. Aim to educate your team about the value of contributing early and often. This can help bring up the average contribution rate and protect HCE contributions.

3. Use payroll automation

Tracking who's an HCE, who owns what, and how much everyone contributed? That’s a lot to manage manually. Automated payroll platforms  — like Remote — can help simplify HCE classification, reporting, and testing with built-in compliance features.

4. Run tests early and often

Where possible, don’t wait until the end of the year. Run mid-year compliance checks to spot potential issues and course-correct in time. This gives you breathing room and avoids last-minute surprises.

What to do if you’re audited

If you’re ever audited by the IRS or the Department of Labor, 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.

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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 — helping you stay compliant and reducing manual work. See how it works, or speak to one of our friendly experts today.

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