401(k) Contribution Limits for Highly Compensated Employees

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 401(k) 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 401(k) 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.

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
For 2021, the 401(k) 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.
The goal of the nondiscrimination test is to make sure that HCEs and non-HCEs contribute a fair amount. This ensures that the contributions do not favor one group, specifically HCEs, over another which could potentially lead to tax fraud.
First, HCEs can contribute to their Roth IRA accounts. Second, they can invest in a non-deductible traditional IRA followed by converting it into a Roth IRA. They can also consider making backdoor Roth contributions or opening a health savings account.
According to the IRS, compensation means wages as well as earnings from self-employment. It may also mean commissions, taxable alimony, and separate maintenance payments, taxable unemployment compensation benefits, and some tips.

401(k) Plan | A Complete Beginner's Guide

401(k) Meaning

The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.

Traditional 401(k) vs Roth 401(k)

There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.

Contributing to Your 401(k) Retirement Plan

Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.

Pension vs 401(k)

Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.

How Much Should I Contribute to My 401(k)?

Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.

Plan in Advance

Allow us to help you prepare and plan for your retirement ahead. Contact a financial advisor in St Helena, CA or visit our financial advisor page for other details.

401(k) Plan FAQs

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, 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.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.