Highly Compensated Employee

How to overcome being designated a highly compensated employee

Congratulations! You’ve moved up the corporate ladder steadily increasing your income. The bad news, you’ve been designated a highly compensated employee. Although it’s good for your bottom line, a highly compensated employee is subject to reduced 401(k) contribution limits. There are ways to overcome the highly compensated employee label, unfortunately, none of them are as beneficial as just contributing to the 401(k).

Who is a highly compensated employee?

A highly compensated employee (HCE) as defined by the IRS is an individual who:

  • Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
  • For the previous year, received compensation from the business of more than $135,000 ($130,000 if the prior year is 2020 or 2021), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation. 

Let’s put a little more detail in the IRS’s definition. The 5% interest rule doesn’t just count what *you* own. It also includes the ownership of your spouse, children, and grandchildren working for the same company. If you own 2% of the company, your wife owns 2%, and your son owns 1%, and your granddaughter owns 2%, you’re a highly compensated employee because the total ownership equals 7%.

The top 20% rule is when compensation is over $125,000 and you’re in the top 20% of employees ranked by compensation, your employer can designate you an HCE. Once made, the election applies until your employer revokes it. Compensation includes overtime, bonuses, commissions and salary deferrals made toward cafeteria plans and 401(k)s. I’m sure you thought the HCE threshold was a little higher than $135,000. The reality is most HCEs have incomes much higher than $135,000. My unscientific analysis indicates most HCEs have income over $250,000.

What’s the point of the HCE?

Each year, the IRS requires employers to ensure pre-tax benefit plans don’t favor highly compensated employees through non-discrimination testing. For example, someone earning $300,000 has the ability to contribute more than someone earning $30,000.

Although somewhat more complicated, for this purpose we can generally say the average contribution rate of all HCEs cannot be more than 2% above the average contribution rate of non-highly compensated employees.

For example, if the average contribution of non-HCE’s is 3% of their compensation, the average contribution of the HCEs cannot exceed 5% of their compensation.

401(k) & the HCE

The 401(k) contribution limit is $20,500 (2022), those 50 and older are allowed a catch-up contribution of $6,500. There is usually some form of employer match as well. All in all, it’s a pretty sweet savings vehicle, unless of course you’ve been designated an HCE by your employer. Then things get complicated.

For example, if your compensation is $250,000, and you’re planning to max out your 401(k) contribution of $20,500, but you’re a designated HCE and limited to 5%, that would limit your contribution to $12,500.

How to minimize the HCE pain

There are alternatives for the HCE when it comes to the ability to save and reduce taxable income.

1. Catch-up contribution

There is one significant exception to the HCE 401(k) restriction – If you’re 50 or older the catch-up provision that allows you to contribute an extra $6,500 per year IS NOT LIMITED BY BEING AN HCE.

2. Contribute to a Health Savings Account (HSA)

An HSA is a medical expense account only available to those enrolled in a high-deductible health plan (HDHP). Individuals can contribute up to $3,650 (2022), and families, $7,300, plus an additional $1,000 a year if you’re 55 or older.

An HSA is like the holy grail of savings. Tax-free contributions, tax-free growth, and tax-free distributions when used for health care expenses. Can you tell I love HSAs? Learn more about why I like them so much in our post 7 Ways an HSA Can Help You Now and In Retirement.

3. Make Non-Deductible Traditional IRA Contributions

If an employer retirement plan covers you and your income is above certain income limits, you cannot deduct your contributions to a traditional IRA. The deduction phases out, in 2022, is when your modified adjusted gross income is between $68,000 and $78,000 (single) or $109,000 and $129,000 (married filing jointly). When your income is above those figures the ability to deduct contributions is wholly eliminated.

That doesn’t prevent you from opening a traditional IRA and making contributions, but they are considered after-tax contributions. All earnings/growth are still tax-free. The contribution maximum for an IRA is $6,000 (2022), and if you’re 50 or older, you can make a $1,000 catch-up contribution.

4. The Backdoor Roth IRA strategy

Highly compensated employees may be interested in employing the backdoor IRA strategy – converting a non-deductible IRA (mentioned above) into a Roth IRA.

Here’s how it works. After you open your traditional IRA and make nondeductible contributions, open a Roth and then convert the traditional IRA to a Roth IRA. The best part is since the funds in the non-deductible IRA are after-tax, you don’t have to pay tax on the conversion.

However, to fully realize the benefit of a backdoor Roth IRA, you can’t have other traditional, SEP, or SIMPLE IRAs. Otherwise, those other accounts dilute the tax advantage, and the conversion will not be completely tax-free.

This strategy can be an annual occurrence, but it’s a complicated process. To learn more, check out our blog The Backdoor Roth IRA: Sneak into the Benefit.

5. Deferred Compensation

Many companies offer a deferred compensation plan. The plan allows you to defer a set percentage or amount of your salary, and taxes on that salary, until a later date, typically after you retire or quit. You can opt-in during the open enrollment period, and there are no limits to the amount you can defer.

Although there is no matching, there are investment options similar to a 401(k). That means there is a potential for gain and a risk of loss.

There are other caveats. First, this deferred comp account is an asset of the company. If they go bankrupt, you will get nothing, unlike a 401(k) which is your asset. Secondly, you need to review the plan rules to determine the payout schedule once you leave or retire, which is usually paid out over 5, 7, or 10 years, or something similar and is considered taxable income at that time.

A deferred comp plan is a powerful tool for long-term financial planning (I sense a future blog topic).

6. Open a Taxable Account

A taxable account may be an option. There are no contribution limits, unlike retirement accounts, but there is no tax deferral on earnings or tax-avoidance on capital gains. On the flip side, distributions are not considered taxable income.

I think a taxable account gets shortchanged when discussing savings and retirement. It’s another bucket of potential income in retirement and that’s not a bad thing. Don’t discount it.

7. Deferred variable annuity

Although I’m not a big fan of annuities, they do have their place in retirement planning. One of those places is for an HCE. An excellent low-cost deferred variable annuity can in many respects be similar to a non-deductible IRA but without the contribution limits.

Distributions will be a mix of taxable and tax-free (return of principal) monies. Like the taxable account above, it can be another valuable bucket of retirement income.

8. Spouse max out benefits

Your spouse can max out their contributions to a 401(k), as long as they aren’t also designated an HCE. Although this is the easiest solution, it may or may not be enough.

Highly compensated employee blues

I know, just when you can actually afford to sock away more, you’re labeled a highly compensated employee. You can’t win. It’s a good problem to have, and you can get creative to work around these restrictions and find ways to maximize your savings potential.

If you need assistance navigating the possibilities and determining the best course of action, feel free to contact us.