Highly compensated employees refer to the employees who own more than 5% of the interest in a business or receive compensation above a certain amount determined by the Internal Revenue Service (IRS). Highly compensated employees are differentiated from non-highly compensated employees for 401(k) retirement plan purposes.
A highly compensated employee is distinguished from the non-highly compensated employees by the IRS for the 401(k) retirement plan administration purpose.
An individual who owns above 5% interest of a business or receives compensation above a certain amount (i.e., $130,000 for the 2020 and 2021 tax years) from a business is considered a highly compensated employee.
The IRS applies additional limitations over the highly compensated employees’ contributions through the nondiscrimination test to ensure all the employees can equally benefit from their retirement plans.
Understanding Highly Compensated Employees
The differentiation of highly compensated employees from the general employees is a concept under the IRS retirement plans. The purpose is to ensure that all the employees in a business can benefit equally from their retirement plans.
The IRS sets two criteria for highly compensated employees. Any individual who meets one of the criteria is classified into the highly compensated employee category.
An individual who owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received; or
For the preceding year, received compensation from the business of more than $125,000 (if the preceding year is 2019 and $130,000 if the preceding year is 2020 or 2021), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.
The compensation is defined not only to include the regular recurring payments from the employers but also to cover the bonuses, commissions, overtime payments, and etc.
The 5% of interest is measured based on the value of shares of a business. It includes the interests attributed to the employees themselves, their spouses, children, and also grandchildren in the same company.
For example, an individual owns 2.0% of the shares of a business, his wife owns 1.8%, and their child owns 1.5% of the same business. Their total ownership adds up to 5.3%, which is above the 5% threshold and thus makes the individual a highly compensated employee.
401(k) Limitations Over Highly Compensated Employees
The 401(k) plan is a tax-deferred defined-contribution pension plan. Employees can make contributions to their plans as much as they want but are capped at $19,500 annually for 2020 and 2021. The contributions may be matched by employers by a certain percentage. Employees choose their own investments and bear risks.
Highly compensated employees are able to make greater contributions and benefit more from the tax deduction, especially in a higher tax bracket. In order to allow all the employees to equally benefit from their retirement plans, the IRS sets additional limitations over the number of contributions that highly compensated employees can make.
According to the IRS, all 401(k) plans must take a nondiscrimination test every year. If the average contribution-to-salary ratio of highly compensated employees is more than 2% above the ratio of other employees, the plan fails the nondiscrimination test.
For example, the non-highly compensated employees of a company contributed 6% of their salaries on average in a year. The highly compensated employees could only contribute no more than 8% of their salaries in that year. Otherwise, the plan will fail the test. All the contributions must be distributed back to the employees.
Other Considerations of Highly Compensated Employee
Highly compensated employees are only eligible to make a limited number of contributions to their 401(k) plan. However, there are other approaches for them to increase their retirement savings. One is to make post-tax contributions to traditional Individual Retirement Accounts (IRAs) or to open a backdoor Roth IRA.
Contributions to Roth IRAs are not tax-deductible, but the withdrawals are tax-free. Individuals earning more than $139,000 annually are not eligible for Roth IRAs, but the backdoor Roth IRA provides an opportunity for highly compensated employees to convert their traditional IRAs to Roth IRAs.
A Health Savings Account (HSA) can be another choice. HSAs can be funded with pre-tax income, and the withdrawals are also tax-free as long as they are used to cover qualified medical expenses. Although HSAs offer appealing tax benefits, the withdrawal rules are very restrictive. Withdrawals for non-qualified expenses before the age of 65 will be taxable and punished with 20% penalties. The monthly maintenance fees and transaction commissions can be another drawback.
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