Highly Compensated Employees and Your 401(k) Plan

Many organizations have highly compensated employees as well as key employees, which typically includes the business owner. With these employees in place, it’s imperative that you keep your company’s 401(k) plan compliant.

To start, consider that highly compensated employees differ from other types of employees.

Highly Compensated Employees vs. Key Employees

To determine if an employee is a highly compensated employee, the IRS requires two tests:

Ownership Test: Determines if an employee or business owner owns greater than 5% of the business at any time during a plan year or during the 12 months preceding the plan year regardless of their compensation.

Compensation Test: Determines if an employee receives more than $150,000 in compensation during the lookback year, as of 2023.

In contrast, key employees:

• Own greater than 5% of the company at any time during the plan year, or
• Own greater than 1% of the company at any time during the plan year and earns more than $150,000 for the plan year, or
• Is an officer at any time during the relevant plan year and earns more than $215,000 (in 2023)

It is possible to be both a key employee and an HCE if conditions are met.

HCEs and Compliance Testing

To ensure that HCEs and non-HCEs receive equal treatment within the employer-sponsored 401(k) plan, employers must perform annual non-discrimination testing. These tests include:

The Actual Deferral Percentage (ADP) Test

This test compares salary deferrals of HCEs to non-HCEs. This test is conducted by comparing the average deferral percentage for HCEs to the average deferral percentage of non-HCEs. To satisfy IRS requirements, the following must occur:

• The annual contribution rate of HCEs does not exceed 1.25 times that of non-HCEs ADP, or
• The ADP of HCEs is not more than 2 percentage points greater than that of non-HCEs

Actual Contribution Percentage (ACP) Test

While this test is like the ADP test, it is applied to employer-matching contributions as well as the employee post-tax contributions. For this test, the average contribution percentage for HCEs is compared to that of non-HCEs.

To satisfy non-discrimination requirements, the same criteria that satisfies the ADP test is required.
In the event a plan fails ADP or ACP testing, excess contribution amounts may be returned to HCEs or a corrective contribution to non-HCEs may be required. Deadlines for corrections apply.

Top Heavy Test

The top-heavy test specifically applies to key employees, as defined above. If the accrued benefits of key employees exceeds 60% of all plan assets valued on the last day of the preceding plan year, the employer would need to correct this ratio by making a minimum contribution to non-key employees.

Safe Harbor Plans for Businesses with Highly Compensated Employees

Safe harbor plans are not deemed to pass ADP, ACP and Top Heavy testing, making this a smart retirement option to offer employees if you’re looking to reduce the risk of failing compliance tests.

There are two types of Safe Harbor 401(k) plans:

Traditional

The employer offers a basic match of 100% match of the first 3% and 50% of the next 2% of deferred employee compensation. There is also an available enhanced matching formula.

Non Elective Contribution

In lieu of a match, an employer can opt for a non-elective contribution (NEC). With the NEC option, the employer has to fund the employee account regardless of whether or not the employee made any contributions to the account. The amount of the NEC must be 3% of employee’s compensation.

HCEs may be exempt from receiving either of these options if this option is adopted during the plan’s inception.

Safe Harbor with Auto Enrollment

Employees are automatically enrolled and may elect to opt out. Automatic escalation of the default enrollment percentage is generally required. The basic match option is100% on the first 1% of compensation, plus 50% on the next 5%. Non elective contribution for employers can is another option for the Safe Harbor auto enrollment plan.

Other Options for Highly Compensated Employees

To avoid possible consequences of over-contributing to an employer-sponsored 401(k) account, highly compensated employees can choose to place their additional funds in other types of accounts. Human resources departments and plan administrators may consider giving this additional guidance to HCEs.

• Possible catch-up contributions: Employees aged 50 or older can make catch-up contributions regardless of compensation. For 2023, the contribution limit for those age 50 or older is $7,500. Catch up contributions are excluded from ADP testing.
• Health Savings Accounts (HSA): Highly compensated employees who subscribe to a qualified high deductible health plan can contribute to these health accounts. These accounts have a contribution limit of $3,850 for single plans, and for a family, the limit is $7,750.
• Roth IRA contributions: Money that is contributed to a Roth IRA is done on an after-tax (tax deductible) basis. For those that are under the age of 50, the contribution limit to a Roth IRA is $6,500 in 2023.

For businesses with highly compensated employees, compliance is likely top of mind. If you have questions about keeping your 401(k) compliant, our support team is here to help. Our sales team is also available to answer any questions about setting up a Safe Harbor plan for your organization.

This content is for educational purposes only, is not intended to provide specific legal or financial advice and should not be used as a substitute for the legal advice of a qualified attorney or financial professional. The information may not reflect the most current legal developments, may be changed without notice, and is not guaranteed to be complete, correct, or up to date.