What is a highly compensated employee?

Highly compensated employee (HCE) definition and meaning

According to the Internal Revenue Service (IRS), a highly compensated employee (HCE) passes one of the following tests:

• Ownership test: The individual has owned over 5% of the interest in the business at any point during the year or the prior year, no matter how much compensation they earned.
• Compensation test: The individual received more than $155,000 from the business for the prior year in the 2024 tax year or $160,000 from the business for the prior year in the 2025 tax year and are in the top 20% of employees when ranked by compensation.

What is the purpose of defining highly compensated employees?

By defining highly compensated employees and separating them from non-highly compensated employees, there is less discrepancy in the retirement benefits workers receive. This distinction allows the IRS to ensure that the tax-deferred advantage of 401(k) accounts doesn’t favor one group of employees more than others.

What is a highly compensated employee 401k in 2024?

In 2024, the 401(k) contribution limits were $23,000 for employees under 50 and $30,500 for those who are 50 or older. These amounts will go up to $23,500 for individuals under 50, $31,000 for those between 50 and 59 and 64 or older, and $34,750 for employees who are 60 to 63 years old in 2025. Whether highly compensated employees can contribute up to these limits depends on how much the non-highly compensated employees of a business contribute to their 401(k) accounts.

Who is considered a highly compensated employee in 2025?

Per the IRS, any employee who receives compensation that exceeds $160,000 and falls in the top 20% of employees when ranked by compensated is classified as a highly compensated employee in 2025. This compensation threshold is up from the $155,000 limit in 2024. It’s important to note that “compensation” goes beyond regular wages and also includes overtime, commissions, bonuses, and salary deferrals toward 401(k) plans.

What’s the nondiscrimination testing threshold for highly compensated employees?

Annual nondiscrimination tests can ensure that the average contributions of highly compensated employees are no more than 2 percentage points higher than the average contributions of non-highly compensated employees. Also, the total contributions of non-highly compensated employees can’t be more than double the total contributions of non-highly compensated employees. In the event a 401(k) does not pass nondiscrimination tests, your business must resolve the issue to avoid losing its tax-qualified status and facing financial consequences.

To do so, you can make additional contributions to the 401(k) accounts of non-highly compensated employees or require highly compensated employees to withdraw a portion of their contributions. Lets say, the non-highly compensated employees of a company contributed an average of 5% of their salaries in a given year. In this case, the highly compensated employees may only contribute no more than 7% of their salaries in that  year. If their contributions exceed 7%, the company has failed the nondiscrimination test.

Are there other retirement savings options for highly compensated employees?

Even though the IRS may limit the number of contributions highly compensated employees can make to their 401(k) plan, there are other ways these individuals can boost their retirement savings. They may contribute after-tax dollars to an Individual Retirement Account (IRA) or take advantage of a backdoor Roth IRA. Other options include Health Savings Accounts (HSAs) and taxable brokerage accounts.

Highly compensated employee (HCE) scenario

Imagine we have a company with 8 employees, including:

• Kelly, the CEO receives $600,000 and earns 90% of the company.
• Mark earns $300,000.
• Michelle earns $250,000.
• Steven earns $80,000 but owns 10% of the company.
• Four other employees each earn $50,000 or less.

In this scenario, Kelly, Mark, and Michelle would be considered highly compensated employees because they each earn more than $155,000 (2024) or $160,000 (2025). Steven would also be classified as a highly compensated employee because even though he only makes $80,000, he owns more than 5% of the company. The four other employees would be non-highly compensated employees because they don’t pass the compensation or ownership test.