What Is a Highly Compensated Employee (HCE)?

A Highly Compensated Employee (HCE) is a classification used by the IRS to determine which employees are considered to earn a high income or hold significant ownership or decision-making power in a business. This designation plays a critical role in administering qualified retirement plans such as 401(k)s, ensuring that benefits do not unfairly favor owners or top earners over the rest of the workforce. The concept of the HCE exists primarily to enforce non-discrimination testing — a set of annual requirements designed to protect the interests of rank-and-file employees.

Understanding who qualifies as an HCE is essential for employers, plan administrators, and business owners, as the classification can affect how much certain employees are allowed to contribute to tax-advantaged retirement accounts and whether a company’s plan remains in compliance with IRS rules.

IRS Definition of a Highly Compensated Employee

According to the IRS, an individual is considered a Highly Compensated Employee if they meet either of the following criteria:

1. Ownership Test: The employee owns more than 5% of the business at any time during the current or preceding year, regardless of how much compensation they receive.
2. Compensation Test: The employee received compensation above a certain threshold during the preceding year. For example, the threshold for 2025 is $160,000 (and this amount is subject to periodic adjustment for inflation). Employers may also elect to use a top 20% rule, limiting the HCE group to the highest-paid 20% of employees, depending on the plan design.

An employee only needs to meet one of these conditions to be classified as an HCE. The ownership percentage includes both direct and indirect ownership, such as shares held by family members or through entities, depending on IRS attribution rules.

Purpose of HCE Classification

The HCE classification exists primarily to prevent retirement plans from disproportionately benefiting company owners or highly paid individuals. This is accomplished through non-discrimination testing, which includes the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. These tests compare the average contributions of HCEs to those of non-highly compensated employees (NHCEs).

If HCEs contribute significantly more than NHCEs, the plan may fail testing, triggering required corrective actions. These may include returning excess contributions to HCEs or making additional contributions to NHCEs.

By identifying HCEs, the IRS ensures that retirement plans are inclusive and not used primarily as tax shelters for executives or business owners. This also means that companies must be mindful when planning employer matches or bonuses tied to deferred compensation plans.

Planning Implications for Employers

Employers need to understand the HCE classification to properly design and administer retirement plans. Failing to track and manage contributions across HCE and NHCE groups can lead to failed nondiscrimination tests, penalties, or costly corrective distributions.

Some employers may limit HCE contributions voluntarily to avoid failed testing, especially in smaller companies where a handful of individuals account for most of the plan contributions. Others may opt to implement safe harbor 401(k) plans, which automatically satisfy most testing requirements if the employer commits to making certain mandatory contributions for all employees.

The classification may also affect how executive compensation packages are structured, particularly in closely held businesses or partnerships. For example, it may influence decisions on profit-sharing allocations, bonuses, or use of supplemental executive retirement plans (SERPs) outside the qualified plan space.

Impact on Employees

For individuals classified as HCEs, this status can restrict how much they’re allowed to contribute to a 401(k) plan, particularly if the plan fails nondiscrimination testing. While the IRS sets an annual contribution limit for all employees ($23,500 in 2025, plus an additional $7,500 for those 50 or older), HCEs may be required to withdraw some of their contributions if average participation by NHCEs is low.

This limitation can be frustrating for high earners looking to maximize retirement savings through tax-advantaged plans. As a result, many HCEs explore additional strategies, such as after-tax contributions (if allowed), Roth 401(k) options, or taxable investment accounts to continue saving for retirement.

Employees also should note that HCE status is determined based on the prior year’s compensation or ownership, so it's possible to be reclassified from year to year as salaries or company structures change.

The Bottom Line

A Highly Compensated Employee is not just a label based on income or ownership — it has direct implications for retirement plan compliance, contribution limits, and employee benefits. For employers, correctly identifying HCEs helps ensure retirement plans remain fair and legally compliant. For employees, particularly high earners or small business owners, understanding this classification can help in developing more effective retirement and compensation strategies.