Understanding Highly Compensated Employees
Highly Compensated Employees (HCEs) must be identified every plan year in order to perform the required non-discrimination testing. Non-discrimination testing was put into place to ensure all employees benefit from the company retirement plan. This concept of ‘fairness’ is intended for the greater good of all of those in the plan, however, sometimes this testing can lead to unfair results for the HCEs; like lower contribution limits or mandatory withdrawals on portions of their account balances.
Who is a Highly Compensated Employee?
Although the term ‘Highly Compensated Employee’ implies those employees in the plan that earn the highest salaries, that is not always the case. A Highly Compensated Employee (HCE) can be any one of the following:
Or who owns more than 5% of the business in the current or previous year; the ownership can be direct ownership or in some cases it can be indirect as in the case of an owner’s child where the ownership is “attributed” to the child through the stock attribution rules.
Or if there are multiple HCE’s; an employee who earns more than the indexed compensation for the preceding year and is among the top 20% highest paid employees.
So even if your salary is $30,000, if you own 5% or more of the company, you are a Highly Compensated Employee.
Also known as Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP), these tests should be performed annually on the 401(k) plan by a Compliance Consulting firm, such as TriStar. These tests compare the ratio of HCE’s deferrals to non-HCE’s deferrals and the HCE’s employer matching contributions to the non-HCE’s employer matching contributions. Rank-and-file employees must be included in the tests, even if they aren’t participating in the plan. Therefore, those non-HCEs who do not contribute or contribute at very low rates to the plan could tip the scales for the HCE’s who are maxing out contributions, making the tests fail and then causing the HCEs to take refunds of their salary deferral contributions.
In general, if the average deferral or contribution rate of the HCE group exceeds the average deferral or contribution rate of the non-HCE group by more than 2%, the test fails, and steps must be taken to correct the failure. When this happens, the company would either have to make additional contributions for the non-HCE group or require the HCE group to take distributions from the plan (a.k.a withdraw their money and pay taxes on it).
Plans that fail testing on a regular basis should consider redesigning their 401(k) plan. There are many 401(k) features that can prevent failed compliance testing and TriStar can design a plan with these considerations. Keep in mind, the information in this article is intended for general information purposes and every plan is different. It is always very important to reference your plan document for information about your specific plan. If you have any questions about highly compensated employees or discrimination testing, don’t hesitate to give us a call!