What Is a Highly Compensated Employee?
According to the IRS, highly compensated employees are defined as follows:
- Someone who receives compensation amounting to $130,000 or more from the business for the year 2021 or $135,000 for the year 2022, or
- Someone who owns more than 5% of the company regardless of compensation
It is important to note that per the first rule mentioned above, compensation covers all income an employee receives from the company which may include such items as bonuses, commissions, and other types of incentive pay.
The 5% mentioned in the second rule above also covers company ownership by spouses, children, and grandchildren who work under that one single company. This means that if someone owns 4% of a company, they are still going to be considered HCEs even if that one percent is divided among several people such as their spouse and children.
In addition, the IRS also states that an employee may be classified as HCE especially when the company makes a top-paid election if he is among the top 20% of employees by compensation.
401(K) Contribution Limits for Highly Compensated Employees
The IRS has established the following limits:
For 2021, the 401k contribution limit is set at $19,500 or an additional $6,500 as catch-up contributions for those who are at least 50 years of age. This makes the contribution limit total $26,000 for those age groups.
HCEs may contribute based on these limits or depending on the non-HCEs contribution amount.
Companies conduct nondiscrimination tests each year in order to determine whether HCEs are contributing too much in comparison to those who are considered non-HCEs.
It should ensure that HCEs should not contribute more than 2% higher than the average amount contributed by the non-HCEs. Total HCE contributions should also not exceed 2% of the total contributions of non-HCEs.
If the tests fail, companies may choose from several options including:
- Decreasing or eliminating the company match for HCEs
- Increasing the company match for non-HCEs
- Providing a combination of both matches
Retirement Account Options HCEs Can Consider
In the event that HCEs want to contribute more than these limits due to company matching contributions or other incentives included in their 401k plan, there are five options which include:
Contributing to a Roth IRA
Roth IRAs allow contributions up to $140,000 for single filers or $208,000 for those who are married filing jointly. These limits are applicable for the year 2021.
Roth IRAs that are at least five years old will allow eligible withdrawals to be tax-free during retirement.
Contributing to a Non-deductible Traditional IRA
Since traditional IRAs prohibit tax-deductible contributions if an employee’s income reaches more than $76,000 for single filers or $125,000 if married filing jointly for the year 2021, HCEs may contribute to a traditional IRA with pre-tax dollars instead.
Making Backdoor Roth IRA Contributions
This option requires an HCE to first contribute to a non-deductible traditional IRA followed by converting the account into a Roth IRA.
Opening a Health Savings Account (HSA)
Although this is an employer-sponsored benefit, employees can contribute money to their accounts through pre-tax payroll deductions as long as they meet certain requirements.
Going for a Taxable Brokerage Account
Investing in a taxable brokerage account will make employees owe taxes on their contributions.
However, there are no contribution limits to restrict them and the earnings will be subject to long-term capital gains tax rather than income tax which somehow saves them money.
The Bottom Line
HCEs can maximize their retirement contributions by considering all available options including 401(k) plan limits and traditional IRA conversions. They should also carefully consider the pros and cons of each option to ensure that they get more savings on their next tax filing.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.