What is a Highly Compensated Employee (HCE)?
You might be asking yourself, “Am I an HCE?”
Well, according to IRS guidelines, HCEs meet one or both of the following standards:
- Officers of a company who earn over a specific gross income threshold ($150,000 in 2023) and fall into the company’s top 20% of income earners, or
- Owners holding more than 5% of the company’s stock or capital during the preceding year
Every year, the IRS adjusts these income thresholds, including various forms of compensation like bonuses and overtime in their calculations.
Being an HCE has its perks since it usually means having a high base salary, but it can lead to potential restrictions on 401(k) elective salary deferrals and tax deductions. Companies offering 401(k) plans have to prove to the IRS that their plan doesn’t favor highly compensated plan participants, and they must pass nondiscrimination tests to prove that non-HCE employees are benefiting from the plan as much as HCEs are.
That’s why exploring alternative pre-tax and post-tax retirement savings options and navigating all retirement planning annual limits is essential for HCEs.
401(k) Contribution Limits for Highly Compensated Employees
Now, let’s talk specifics about 401(k) contribution limits. Generally, there’s a maximum annual contribution limit set for all employees. In 2023, that limit is $22,500.
Additionally, if you’re aged 50 or older, you’re allowed catch-up contributions. In 2023, that catch-up number is set at $7,500.
Lastly, there’s a total contributions limit that includes both employee contributions and employer contributions. For 2023, it’s $66,000 (plus any catch-ups if you’re eligible).
However, if you’re an HCE, there are additional restrictions to be aware of. Your contributions may be limited based on the results of the top-heavy test, which determines if the majority of a 401(k) plan’s assets are owned by key employees or highly paid employees (those who own more than 5% of the business or earn over a certain amount).
If a plan is considered top-heavy, HCEs might face lowered contribution limits to balance the employer-sponsored plan for non-highly compensated employees. To navigate these restrictions and maximize contributions, employers may offer a safe harbor plan which guarantees certain conditions to avoid the need for nondiscrimination testing.
To pass the nondiscrimination testing, a company must demonstrate that HCE average contribution rates aren’t more than 2 percentage points higher than those of non-HCEs. If the company fails this testing around elective deferrals, it will have to take corrective action.
5 Retirement Savings Alternatives for Highly Compensated Employees
There are alternatives if you’re one of your company’s HCEs and face limitations to your 401(k) savings. Let’s look into other types of plans in detail.
1. Traditional IRA
While HCEs may not be able to make tax-deductible contributions that reduce income tax, a traditional IRA still offers tax-deferred growth and acts as an additional savings option. With a traditional IRA, even if you contribute after-tax dollars, your earnings grow tax-deferred until you withdraw them at retirement.
No matter how high your compensation, you can contribute to a traditional IRA; whether you get a tax deduction is another matter entirely. HCEs will, in all likelihood, not receive a tax deduction for traditional IRA contributions. But they can use their traditional IRA as a holding account to make future tax-free Roth conversions, if they adhere to the pro-rata rule.
2. Roth IRA
A Roth IRA is another alternative, but direct contributions are unlikely to be available for the grand majority of HCEs. There are income limitations for contributions, which blocks out most HCEs from putting money in directly (though with the Backdoor Roth IRA, they can still access the Roth).
With a Roth account, all contributions grow tax-free, and withdrawals during retirement are also tax-free. Moreover, there are no mandatory distributions during the owner’s lifetime, which allows for a greater degree of flexibility and control.
3. Backdoor Roth IRA
The Backdoor Roth IRA is essentially a method to get around the income limitations of a Roth IRA. You start by contributing to a traditional IRA (without claiming the tax deduction) and then convert the money to Roth IRA. However, there can be potential tax implications and pitfalls (see: the pro-rata rule), so it’s recommended to consult a financial advisor and/or plan administrator before going down this route.
4. Health Savings Account (HSA)
If you’re enrolled in a high-deductible health plan, an HSA can be an excellent option. It allows you to contribute pre-tax dollars, which can grow tax-free and be withdrawn tax-free for qualified medical expenses. Moreover, money invested in an HSA can be invested in various securities for potential long-run growth.
5. Taxable investment accounts
Lastly, consider taxable investment accounts. While they don’t offer the same tax advantages as other options, they have no contribution limits or income restrictions, making them an excellent option for HCEs.
Some examples include general brokerage accounts that you can open up at an online broker of your choice. They offer the flexibility to access your investments anytime, not just in retirement. You’ll also have a broader range of investment options than in a 401(k), allowing you to diversify your retirement savings.
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