What is a Highly Paid Employee (HCE)?
A Highly Paid Employee (HCE) is, according to the Internal Revenue Service, anyone who has done any of the following:
- Owned more than 5% of the interest in a business at any time during the year or the previous year, regardless of the amount of remuneration that this person earned or received
- For the previous year, received compensation from the business of more than $ 125,000 if the previous year is 2019; and $ 130,000 if the previous year was 2020 and, if the employer wishes, were among the 20% of employees highest ranked by compensation
Understanding Highly Paid Employees (HCE)
Tax-deferred retirement plans such as 401 (k) plans have been implemented by the Internal Revenue Service (IRS) to provide equal benefits to all workers. Initially, all employees could contribute as much as they wanted, with the total employer contribution of up to $ 19,500 per year.
High wages could contribute much more than other employees and were therefore likely to benefit more from the tax exemption regime, which allowed them to significantly reduce their tax obligations. Since all employees did not receive the same benefits from pension plans, the IRS established rules prohibiting senior employees from contributing beyond a certain limit based on the average contribution of other employees.
The Internal Revenue Service (IRS) requires that all 401 (k) plans pass a non-discrimination test every year. The test separates employees into two groups: non-highly paid employees and highly paid employees (HCE). By examining HCE contributions, the compliance test determines whether all employees are treated equally through the company’s 401 (k) plan.
Non-discrimination provisions are put in place so that employee retirement plans do not discriminate in favor of highly paid employees. The definition of highly paid employees has enabled the IRS to regulate deferred plans and to ensure that companies do not simply set up pension plans for the benefit of their managers.
The 5% threshold is based on the voting rights or the value of the company’s shares. Interest held by an individual also includes interest attributed to loved ones such as spouse, parents, children, grandchildren, but not grandparents or siblings. An employee with exactly 5% stake in the business is not considered a highly paid employee, while an employee with a 5.01% stake in the business has HCE status. For example, an employee holding 3% of the capital of the company will be considered an HCE if his spouse owns 2.2% of the capital of the same company (the total interest is 5.2%).
If the average contributions of HCEs to the scheme are more than 2% higher than those of non-HCEs, the scheme would fail the non-discrimination test. In addition, contributions from HCEs as a group cannot exceed double the percentage of contributions from other employees.
The contribution of an HCE to its own pension plans depends on the level of participation of non-HCEs in the plan.
In simpler terms, when a company contributes to a defined benefit or defined contribution plan for its employees and those contributions are based on employee compensation, the IRS requires that the company minimize the gap between benefits pensions received by highly paid and lower paid employees. If the employer fails to correct the discrimination, the plan could lose its tax status and all contributions will have to be redistributed to plan members. The employer could also face serious financial and tax consequences due to the distribution of contributions and earnings.
A company can correct any imbalance in its retirement plans by making additional contributions for the group of unpaid employees. Alternatively, the company could make distributions to the HCE group, which will have to make withdrawals from the plan and pay taxes on the withdrawals.
Key points to remember
- A highly paid employee is defined as an employee who holds more than 5% of the interest in a company at any time during the year or the previous year.
- By examining HCE contributions, the federal government’s compliance test determines whether all employees are treated equally through the company’s 401 (k) plan.
- The contribution of an HCE to its own pension plans depends on the level of participation of non-HCEs in the plan.