Highly Compensated Individual Employee (HCI/HCE) – A Designation That Influences Benefits Testing
In plain language: A highly compensated individual employee (HCI or HCE) is a worker who earns more money than a certain threshold or owns significant interest in a company. This label can impact the benefits they receive under different employee benefit plans.
Technical definition: A "highly compensated employee" (HCE), as mandated by IRS regulations, is defined as an individual who either owned more than 5% of the interest in the business at any time during the year or preceding year, regardless of compensation, or for the preceding year, received compensation from the business of more than $130,000 (if the preceding year is 2021 or 2022), and, if the employer elects, was in the top 20% of employees when ranked by compensation.
Understanding the statutory definition of highly compensated employee is vital for HR professionals, plan administrators, and CPAs as it has significant implications for qualified retirement plans' tax-qualified status.
TL;DR
What Is a Highly Compensated Employee in Insurance?
The term "highly compensated employee" or HCE isn't exclusive to insurance yet plays a significant role in some workplace benefits, particularly related to retirement plans. IRS regulations established this definition of highly compensated employee for the purposes of performing nondiscrimination testing on 401(k) plans and other qualified retirement plans.
The HCE threshold typically changes annually according to inflation and other factors as determined by the IRS. The HCE determination is essential because the IRS mandates various nondiscrimination tests to ensure that the amounts deferred by or contributed on behalf of the HCEs don't significantly exceed the amounts for the non-highly compensated employees or NHCEs.
Beyond just the income threshold, an employee can also attain an HCE status through significant stock ownership in the company. If an employee owns over 5% of the business at any time during the year or the preceding year, they are an HCE, regardles of their income.
This HCE designation helps to maintain fairness in the distribution of tax-advantaged retirement benefits and prevent deferred compensation plans from only favoring top-earning employees.
Key Related Terms to Know
Common Questions About HCE
What factors determine the HCE designation?
There are two main criteria for the HCE determination. An employee is considered a highly compensated employee if they owned more than 5% of the business at any time during the year or the preceding plan year. The other factor is income: if a worker received compensation from the business of more than $130,000 (for 2021 or 2022), and, if the employer chooses, was in the top 20% of employees when ranked by compensation for the preceding year, they qualify as an HCE.
How does the HCE status impact retirement plans?
The highly compensated employee designation carries significant implications for benefits testing in retirement plans. Retirement plans must pass nondiscrimination testing each year to maintain their tax advantages. If the plan benefits the HCEs substantially more than the non-highly compensated employees (NHCEs), it could lose its tax-qualified status.
How can a company manage HCE implications on 401(k) plans?
One common method companies use to manage the effects of having HCEs is by making nonelective contributions to NHCEs' accounts. These additions are usually a fixed percentage of the employee's compensation and aren't contingent on the worker making their own contributions. As a result, it helps to balance the plan's benefits and pass the nondiscrimination testing.
What is the ADP testing for HCEs?
ADP stands for Actual Deferral Percentage. This test compares the average salary deferral percentages of the HCEs and NHCEs in a 401(k) plan. If the HCEs' average percentage is too high relative to the NHCEs', the plan fails the ADP test and corrective measures must be taken.
HCE vs. NHCE
Understanding the difference between a highly compensated employee (HCE) and a non-highly compensated employee (NHCE) is vital. Although the distinction may seem simple based on income and share ownership, the implications for retirement plan administration are significant.
Comparison Area | HCE | NHCE
|
Income or Ownership | Earns more than the set threshold or has more than 5% business ownership | Earns less than the set threshold and owns less than 5% of the business |
Coverage | Subject to additional scrutiny in benefits eligibility | Regular coverage with no additional scrutiny |
Nondiscrimination Test Relevance | Plans must pass testing to ensure HCEs do not disproportionately benefit | NHCEs benefits are compared against the HCEs in the nondiscrimination test |
Common mistakes | Excessive contributions that could possibly favor more affluent employees | No significant errors as such |
Real Claim Examples Involving HCI/HCE
Scenario 1: A mid-sized company with several highly-compensated employees failed a nondiscrimination testing for their 401(k) plan. A review revealed that the HCEs were contributing significantly more to the plan than the NHCEs, leading to failed testing. The company had to correct it by refunding excess contributions made by the HCEs.
Scenario 2: A small business owner, unknowingly considered a highly-compensated employee due to owning more than 5% of the business, failed to comply properly with the retirement plan rules. The lack of awareness led to a discrepancy flagged during an audit, requiring the business to revise their benefits setup.
Scenario 3: A large corporation successfully averted failing nondiscrimination testing by prudently making a nonelective contribution to the 401(k) plans of their NHCEs. This foresight resulted in the plan remaining balanced and maintaining its tax-qualified status.
Limitations and Common Mistakes
How to Explain HCE to Clients
To the owner of a small business: An HCE is an employee who, in the last year, either owned more than 5% of the business, or received more than $130,000 in pay. Because we want to keep our 401(k) plan fair for all employees, we must test it each year to be sure it doesn't mainly benefit those who earn the most money or have ownership stakes.
To an HR Manager: As a highly compensated employee, your benefits are scrutinized more closely to ensure equality in our 401(k) plan. IRS rules require us to check that the plan doesn't favor employees making over the set amount, which is $130,000 for 2021 and 2022, or those who own more than 5% of the business.
To a large corporation CFO: We need to keep our eye on the number of highly compensated employees we have. The IRS looks for fairness in retirement plan contributions and could penalize us if the plan primarily favors those earning more than $130,000 annually or owning more than 5% of the company. We may need to make adjustments or nonelective contributions for other employees to balance plan participation.