What Tests Determine Who Is a Highly Compensated Employee?

Q: Just read your column on the 401(a)(17) compensation limit for non-calendar year plans. Does the limit used to determine Highly Compensated Employees work in the same way?

Kimberly Boberg, Kelly Geloneck, Emily Gerard and David Levine, with Groom Law Group, and Michael A. Webb, senior financial adviser at CAPTRUST, answer:

A: It would be great if there were some consistencies between the limits, but unfortunately the answer is no. For those who may not know, for plans that are subject to nondiscrimination testing, a highly compensated employee is generally a type of highly paid employee to whom contributions and benefits may be restricted based on the results of such testing. There are two tests for determining if an employee is an HCE–an ownership test and a compensation test. An employee is an HCE if he or she satisfies either of the two tests.

Compensation Test

While there are dollar amounts that can be used to determine both the 401(a)(17) limit and who is an HCE, the HCE limit uses a completely different determination year—called a lookback year—for its dollar threshold. Generally, an employee is an HCE under the compensation test if he or she received compensation from the employer in excess of a dollar threshold limit (as adjusted) during the lookback year. The lookback year is generally the 12-month period preceding the current plan year. So, if the current plan year is July 1, 2024, through June 30, 2025, the lookback year is July 1, 2023, through June 30, 2024. We would then use the HCE dollar limit for the calendar year in which the lookback year begins as the appropriate dollar threshold. Since the HCE dollar limit for calendar year 2023 is $150,000, an HCE for the plan year beginning July 1, 2024, would be defined as someone who earned more than $150,000 from July 1, 2023, through June 30 , 2024.

To make things even more complicated, a plan can use what is called a calendar year data election to change the lookback year to the calendar year that begins within the lookback year. In the above example, the calendar year that begins within the July 1, 2023, through June 30, 2024, lookback year is the 2024 calendar year. Since the HCE dollar limit for calendar year 2024 is $155,000, an HCE for the plan year beginning July 1, 2024, would be defined as someone who earned more than $155,000 in the 2024 calendar year. Section V of Notice 97-45 discusses the requirements for making a calendar year data election.

For employers whose workforce contains more than 20% HCEs, such employers can elect what is called a top-paid group election that would limit the HCE population to the top 20% of employees ranked by compensation.

Ownership Test

Generally, an employee is an HCE under the ownership test if he or she is a 5% owner at any time during the current plan year or the lookback year, regardless of compensation earned (note: tax-exempts organizations generally do not have owners in this context, so this would generally not apply to 403(b) plans).  

Thus, HCE determinations can be quite complicated. When in doubt, plan sponsors should consult an outside retirement plan counsel who is well-versed in such matters.

NOTE: This feature is to provide general information only, does not constitute legal advice and cannot be used or substituted for legal or tax advice.

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