The IRS classifies you as a highly compensated employee if you meet specific ownership or income standards with your employer. This classification can affect your 401(k) contributions, but only in certain situations.
Definition
What is a highly compensated employee?
A highly compensated employee (HCE) is someone who satisfies either the IRS' ownership test or compensation test. Here's how these two tests work:
- Ownership test: You owned at least 5% of the company at any time during the current retirement plan year or in the 12-month period preceding the plan year.
- Compensation test: You earned more than $160,000 in compensation in the 2025 tax year and are in the company's top 20% of employees by compensation. The IRS makes a cost-of-living adjustment to the compensation threshold every year.
The best way to determine if you're an HCE is asking your employer, especially if you may qualify under the compensation test, as you'll need to find out if you're in the top 20% of earners at your company. Being a highly compensated employee comes into play if your employer's 401(k) plan fails a nondiscrimination test. If a company fails a nondiscrimination test and you're an HCE, a portion of your contributions could be turned into distributions.
Nondiscrimination tests
How a nondiscrimination test works
Many companies offer tax-deferred 401(k) retirement plans for employees. The IRS wants to make sure that the benefit of tax-deferred savings is equally available to all employees and that those benefits don't disproportionately favor highly compensated employees.
To verify this, 401(k) plans must go through a nondiscrimination test every year. A nondiscrimination test involves separating employees who are eligible for the 401(k) into two groups: HCEs and non-HCEs. Deferral rates -- the percentage of a paycheck deposited into a 401(k) -- are calculated for each employee, and then the average deferral rates for the HCE group and the non-HCE group are compared. The deferral rate for the highly compensated employee group must be within an acceptable range of the non-highly compensated employee group for the 401(k) plan to pass.
401(k) rules for HCEs
401(k) rules for highly compensated employees
The rules and limits for 401(k) contributions are normally the same for HCEs and non-HCEs. However, if your employer's 401(k) plan fails the nondiscrimination test, it could affect some of your retirement contributions for that year. In this situation, your employer needs to take corrective action, and there are two options available:
- Make additional 401(k) contributions for non-HCEs. Employers generally need to make contributions for all eligible non-HCEs in this situation.
- Assign and distribute excess 401(k) contributions to HCEs. Highly compensated employees must pay income taxes on the distribution.
It's up to your employer to decide if it will contribute more for non-HCEs or distribute contributions to HCEs. Distributions may not be for a large amount, but they will increase your tax liability for the year. While you can't always avoid this, you can see whether you'd be considered a highly compensated employee when negotiating a job offer. If so, you may want to ask if the company has failed a nondiscrimination test before.
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Example
Example of a highly compensated employee
Here's a hypothetical example of a highly compensated employee: John earns $180,000 in compensation from his employer in 2025. He's also in the top 20% of earners there, which means he passes the compensation test and is considered an HCE for that year. He contributes up to the 401(k) limit of $23,500 for 2025, and he receives an employer match of $9,000, for a total of $32,500.
However, the 401(k) plan fails the nondiscrimination test. John's employer decides to distribute excess contributions to HCEs, and he receives a distribution of $2,000. While that amount was previously tax-deferred, John now needs to pay taxes on it. On the bright side, he was still able to add $30,500 to his 401(k) for the year.
