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Highly Compensated Employee

Definition

A Highly Compensated Employee, often referenced in a business or tax context, is an employee who owns more than 5% interest in the business at any time during the year or the preceding year, or who received compensation from the business exceeding a specific threshold in the preceding year. This threshold is determined by the Internal Revenue Service (IRS) and can change from year to year. These employees often face different rules in relation to retirement and benefit plans due to their higher income status.

Phonetic

The phonetics of the keyword “Highly Compensated Employee” is:- Highly: /ˈhaɪli/- Compensated: /ˈkɒmpɪnseɪtəd/- Employee: /ɪmˈplɔɪiː/

Key Takeaways

Three Main Takeaways About Highly Compensated Employee

  1. Definition: A Highly Compensated Employee (HCE) is an individual who holds significant income as well as key roles and decision-making power within a company. The Internal Revenue Service (IRS) defines an HCE based on ranking and salary, which is subject to annual revision.
  2. Impact on Retirement Plans: HCEs can notably affect the balance of a company’s retirement plan. Due to their considerable earnings, they might be restricted from contributing a larger percentage to the 401(k) plan to prevent it from becoming discriminatory against lower-paid employees. This is checked through nondiscrimination testing each year.
  3. Thresholds: For an employee to be considered as a Highly Compensated Employee, as of 2021, they must earn more than $130,000 in the preceding year or own more than 5% of the business at any time during the present or preceding year, regardless of their compensation level.

Importance

The term “Highly Compensated Employee” (HCE) is significant in business and finance as it refers to employees who have a higher income level within an organization and may receive different benefits or treatment under certain retirement plans. The designation is essential for ensuring the fairness of 401(k) plans and other deferred compensation plans because IRS regulations limit the disparity between the benefits provided to regular employees and HCEs. Identification of HCEs is also integral for non-discrimination testing, which is a part of annual compliance to ensure benefits are not skewed in favor of HCEs. Understanding who qualifies as an HCE helps businesses maintain compliance with these regulations.

Explanation

A highly compensated employee (HCE) plays an integral role in identifying disparities in contributing to retirement plans such as 401(k) between high- and low-income employees. The Internal Revenue Service (IRS) utilizes the HCE designation to ensure that retirement benefits are not being disproportionately utilized by higher earners at the expense of lower earners. This is in line with its desire to provide a fair and equal opportunity for all employees, regardless of their salary levels, to save for retirement. HCE determination has significant implications on retirement planning and compliance with non-discrimination laws. Certain tests are conducted annually, such as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to determine whether contributions made to a 401(k) plan by HCEs significantly outweigh those of non-HCEs. If these mandatory tests find that the plan benefits HCEs excessively, the company may be obligated to take corrective measures such as refunding a portion of the HCEs’ contributions, or boosting contributions for non-HCEs.

Examples

1. Google Executives: According to the IRS, a highly compensated employee is someone who owns more than 5% interest in the business or receives more than $130,000 in salary annually. Google’s top executives certainly fall into this category. For example, in 2019, Google CEO Sundar Pichai made over $280 million, mostly in the form of stock grants, which is well above the threshold designated by the IRS. 2. Investment Bankers: Many investment bankers are also classified as highly compensated employees. These individuals often receive high base salaries along with significant annual bonuses that usually exceed the IRS threshold multiple times over. For example, a Managing Director at a top investment bank could earn a base salary of $500,000, with the potential to earn a bonus of a similar amount or even more.3. Professional Athletes: Many professional athletes are also considered highly compensated employees, since they garner huge salaries for their skills. For instance, NBA player LeBron James who plays for the Los Angeles Lakers, earned more than $37 million in salary alone in 2021, not including other earnings from endorsements and other off-court activities, which clearly categorizes him as a highly compensated employee.

Frequently Asked Questions(FAQ)

Who is considered a Highly Compensated Employee?

A Highly Compensated Employee (HCE) is an individual who, in the preceding year, either owned more than 5% of the interest in the business at any time or received compensation from the business exceeding an annual threshold set by the Internal Revenue Service (IRS).

What is the purpose of identifying Highly Compensated Employees?

Identifying HCE is significant for IRS-regulated employee benefits, like 401(k) plans. These regulations aim to prevent discrimination in benefits to the detriment of lower-paid employees.

How is a Highly Compensated Employee defined for 2022?

For 2022, a Highly Compensated Employee is defined as an employee who earned more than $135,000 in 2021, or owned more than 5% of the business at any time during the year or the preceding year.

Are there any exceptions to the HCE regulations?

Yes, some exceptions exist. For instance, the HCE rules do not apply to governmental plans, church plans, or plans maintained by the employer to comply with laws in countries other than the United States.

How often is the Highly Compensated Employee threshold updated?

The IRS routinely reviews and adjusts the compensation threshold for Highly Compensated Employees each year.

What’s the significance of being classified as an HCE for the employee?

If an employee is classified as an HCE, there may be limitations on the total contributions they can make to tax-advantaged retirement accounts like 401(k) plans. This is to ensure equitable distribution of benefits within a company.

Are Highly Compensated Employee contributions to a 401(k) plan capped?

Yes, they are. This is to prevent HCEs from benefiting disproportionately more than non-highly compensated employees. Overall contribution levels from HCEs are often dependent on the contribution levels of non-HCEs according to the ‘Actual Deferral Percentage’ (ADP) and ‘Actual Contribution Percentage’ (ACP) tests.

What happens if a plan fails the Highly Compensated Employee nondiscrimination tests?

If a plan fails these tests, the company must rectify the situation by either refunding some contributions to HCEs or contributing additional amounts to non-HCEs.

Related Finance Terms

  • Deferred Compensation
  • 401(k) Contribution Limits
  • Nondiscrimination Testing
  • Top-Heavy Pension Plans
  • Salary Deferral Contributions

Sources for More Information

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