Seeking Fairness: 401ks & Highly Compensated Employees

in Retirement Planning by

If you meet the IRS definition of being a highly compensated employee (“HCE”), you may find yourself in an unlikely position come tax-time: having to pay tax on your 401k contributions.

But aren’t 401k contributions tax-free?  They are – but as an HCE, you’d owe tax on any 401k contributions refunded to you. This could happen if your company 401k plan fails its nondiscrimination tests.

Non-discrimination tests are administrative tests associated with 401ks that were put in place to ensure that all employees are benefiting from 401k plans and that company executives are not benefiting disproportionately.  In other words, they’re meant to ensure 401ks are fair.  It’s a great goal, but a potential perverse effect is that you might face lower contribution limits – or worse, that you might have to pay taxes on an amount that you thought you were contributing to your 401k if your plan fails to meet the tests.

In the following post, I review the IRS definitions of an HCE and describe the tests that your employer (or more likely, your 401k recordkeeper) needs to take to ensure your 401k plan is compliant.  And more importantly, I review your options if you find yourself in the situation that your 401k retirement savings are limited because you’re an HCE.

Who Is a Highly Compensated Employee?

For IRS purposes, an HCE is someone who owns a higher than 5 percent stake in a company for the current tax year or the previous year.  You are also considered a highly compensated employee if you were paid more than $115,000 for 2014. In some cases (if your employer had elected this option), you will be considered a highly compensated employee only if you’re paid more than $115,000 and are among the highest-paid 20 percent of employees of your company.

IRS Tests

So how do non-discrimination tests work?  Essentially, they look to see if HCEs are deferring disproportionately more of their income through 401k plans than the rank-and-file employees and also if the total 401k contributions of the executives are disproportionately higher than the total 401k contributions of the other employees. To get into the weeds, the first test needs to show that the average deferral percentage (ADP) is no more than 2% (or 125% of, whichever is more) than non-HCEs. The second test needs to show that the average contribution percentage (ACP) is similar, but also takes into account employer matching and after-tax contributions.

In reality, your HR department should work with your company’s 401k providers to sort out whether the nondiscrimination tests affect your ability to save in a 401k.  If you’re an HCE, your effective annual limit may be lower than the standard $17,500 (or $23,000 if you’re over 50).  Typically, HR should inform you of your maximum contribution in advance, and you won’t have to worry about taxes.  However, if your company’s plan fails the nondiscrimination tests, you will be faced with a refund of your contributions – and owe Uncle Sam tax.

Next Steps?  Talk to HR, and then to Other Employees, or Save Elsewhere.

So as an HCE facing potentially limited retirement savings opportunities, what do you do?

The first step: talk to your employer about setting up the plan as a safe harbor plan.  That means, if your plan meets certain IRS requirements, it can avoid discrimination tests altogether.  You might also ask about a nonqualified deferred compensation plan, which would enable you to save much more than the $17,500 cap on a tax-deferred basis. The plan horizon could even be five or 10 years and you could save for purposes other than retirement. (NB: this sort of plan falls outside the government protections that a 401k plan offers and if the company goes bankrupt, you could lose your money).

If that’s not an option, you can talk to HR about how to get more people in the company to save.  That’s because the equations look at proportionate saving; so getting people throughout the company to save more will increase your potential savings levels. Setting up automatic 401k enrollment for employees and setting default savings rates has proven to help encourage savings.  Further, in the event that a company fails its non-discrimination test, it can elect to distribute a qualified non-elective contribution (QNEC) to some or all of non-HCEs (rather than issue a refund to HCEs).  So if you’re facing a refund, you can ask your HR if they’ve considered this option as an alternative.

If neither of these is an option, you can take matters into your own hands.  What would that mean?  Talking to colleagues about the benefits of retirement planning and touting the benefits of getting the employer match, which is essentially a benefit they don’t have to pay for.  While this course of action may sound implausible, it actually might have the most widespread benefit and is worth a second thought.

And finally, if you’re out of employer-sponsored options, you could also opt to go the IRA route to save additional money of up to $5,500, or $6,500 for those 50 or older.   To learn more about IRA options, check out the Daily Capital write-up about how to think about IRAs.

Want help sorting through your options? Speak to a Personal Capital advisor to help you figure out the best way to save for retirement as an HCE.

Schedule an Appointment with a Personal Capital Advisor Today

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Poonkulali Thangavelu

Poonkulali Thangavelu

Armed with an MBA and over ten years experience in financial journalism, Poonka seeks to break new stories and bring fresh perspective to her readers. Her expertise is in real estate, investing and employer benefits.


  1. Financial Samurai

    Thanks Poonka. I’ve never heard of HCE as it pertains to retirement plans, perhaps because such discrimination doesn’t happen often given if it did, HR wouldn’t be doing their jobs?

    Can you use some sample income figures of a HCE and other employees to help illustrate a point of non compliance and how HR would change the system too comply?


  2. Poonka

    Thanks for your comment, Sam. I’m sure HR people are vigilant about watching for such discrepancies.

    I imagine they won’t want to have to face HCEs who find they have to pay tax on their excess 401(k) contributions since their plan failed the ADP or ACP tests, which are easy enough to figure out.

    That’s why a safe harbor plan would also be a good option.

  3. Derek

    I just searched for and came here looking for info on HCE. I could not understand why I was capped at 5%. I earn 109k and get a bonus that takes me over 115K. I am just stunned I am capped at 5% and not allowed to invest more. It is not like I have lots of cash laying around saving for my retirement. I have to put 3 kids through college.. why am I penalized just because I earn a little over 115k. The cap should be higher so that normal workers are not effected.

  4. Brian

    If you don’t have a lot of cash laying around, and you need money to put your three kids through college, then why are you bothered that you are capped at 5%? Your two statements point at not having enough money available to invest in retirement.
    The reason you’re capped at 5% is because the employees at your company who make less than $115k per year are contributing less than 5% on average. The point of the law is to get people like you to get others to contribute more, either through direct interaction, or pressuring your company to implement policies that encourage others to save.
    First, be happy that you make a decent salary. Second, I suggest that you either do something about it, or stop complaining. I doubt that any of those at your company who make less than you will feel sorry for your situation.

    • DB

      The problem with the 5% cap on HCE’s is that it is usually an “unwritten” rule and the HR guys would call you up and bully you into “willingly” limiting your contribution. Note that 5% on $100,000 is only $5000 and is hardly 401k-worthy (you could do the same in an IRA).

      I think the actual written rules (ie in the full plan description) say something totally different, and I think legally HR should not be allowed to force you to follow their “unwritten” rule based on their facile strategy for passing the ADP test.

    • Dan

      I find this response to Derek’s situation absolutely outrageous. Who do you think you are? Generally, people do not want to be told what to do with their income – rather, they prefer to make their own lifestyle choices. It is not Derek’s fault that some of his co-workers making less than he does decide to live in a way that prevents them from saving more for retirement than they should. Maybe they wanted to buy that new car and consume their income now, maybe they wanted to go on that vacation even though they couldn’t afford it, or maybe they had kids before they should have. Maybe Derek thought about these things and intentionally planned for them. Who is Derek to strike up a conversation at the water cooler to let his fellow employees know they are living beyond their means. And who in the world are you to determine that $115k is officially too much money for somebody to earn relative to others who may lack the ambition Derek does….It’s an absolute shame people like you, Brian, have been allowed to influence policy….Simple solution to retirement savings problem is automatically signing up employees in America into plans and them letting them opt out if they need to, remember choice? If they don’t save enough, then they keep working or scale back. It’s not the fault of the people who plan (yes, even lower income people can plan) to pay for the people who don’t.

    • Jaime

      Brian. I don’t think Derek meant he has surplus cash just laying around his home. From my understanding of Derek’s question, he probably has enough money to contribute to his retirement maximum, in this case $18,000 under 50 years old, despite his ability to fund all 3 of his children’s college education (he doesn’t say if it’s half, all or part of his children’s education). He simply wants to contribute the max allowable without any strings attached.

  5. Cee Cee

    Allow me to sum this up. The HCE limits are socialism in action. The 2014 limit for 401K pre-tax contributions is $17,500. If we are all to be treated equally under the law, that should be the rule. Period. Due to the upcoming generation of baby boomers that will be drawing social security, I will very likely not see benefits for myself when I reach retirement age in 2035. I will also not have a lifetime pension plan like Congress (who voted for this law) or the IRS (who enforces this law). This scares me. A lot. Rather than just being scared and angry, I prefer to take action and save as much as I can. With this new “fairness” rule, I am now handicapped in reaching my investment and retirement goals and ultimately living my senior years without fear of poverty. Why should I be dragged down by my fellow employees because they only contribute 5% toward their 401K? Why should this statistic prevent me from saving for my retirement? What about other companies where the investment average might be 10%? Why does where someone works have any influence on how much percentage can be set aside in a 401K? It doesn’t make sense. The new rule for “fairness” is actually unfair.

    • wdh

      I agree with you. I don’t get the “fair” part of the situation. Why is it our problem if we maxed our contribution limit and someone else didn’t. Change the law to a max percentage of earnings from the outset if you want to make it fair! That way we’ll all be limited to 7% or whatever. Don’t dangle the $17,500 then take it away!

    • Doug

      Very well said!

  6. Retiree1

    CeeCee you’re talking like its the end of the world and now the government is forcing you to spend money. The “statistic” is not “preventing [you] from saving for retirement.” The law is just set up so you don’t get a tax benefit for it. You could always talk to an investment specialist regarding your extra money. Worst case scenario you can just put what you otherwise would have saved in a 401(k) into a regular savings account at the bank. Or, as the author suggests, try to influence your company to entice lower earners to participate. That way, everyone gets to save for retirement and no one is stuck living off the government teat in their old age (something I assume you would look down upon).

    • Anonymous

      I am very well aware of the other options to save out there. I just don’t understand why I have to be handicapped due to others inactivity. 401k offers three benefits for employees: reducing adjusted gross income, company matching and an assortment of decent funds to invest in based on my comfort level with risk. The HCE rule limits me on the first two benefits. It’s not a fairness test. It’s an effort to dumb us down in a monetary way.

  7. Jay

    I have always thought this a patently unfair law because it isn’t right that I am in an engineering consulting company where most people do NOT invest in out 401(k) option, thus preventing me from investing in it because I am an HCE….YET at the large company we consult at, THOSE folks all get to max out their 401(k)s. A FAIR law would affect ALL employees in the USA equally rather than just measure you against what others within your own company are doing. Absolutely horribly unfair and unreasonable law.

  8. Crash

    Everyone is so angry and uninformed these days. The reason for the law is to prevent companies from designing 401k plans that disproportionately benefit their high earners. As HCEs, we have greater ability to contribute, plus an inherent benefit because many plans are based on percentage of pay. As always, the tax code is being used to encourage policy – here, for companies to design plans that appeal broadly and to actively promote those plans to all employees, especially lower earners (encouraging savings in the process). Remember that deferring tax is not some kind of constitutional right – it’s an incentive offered by the govt, and it’s sound policy for them to design that incentive in a way that encourages savings at all income levels. This is not a new rule, it’s been there since the 1980s. Note also there are other ways for your employer to meet the requirements, but they require the company to make extra, fully-vested payments to all employees. That’s why most companies choose the cap. You can lobby your employer to change, but they are making an economic choice. Remember also that some employers don’t even offer a 401K, so maybe be thankful for what you can contribute instead of ranting about unfairness or “socialism.”

  9. Jeff

    What happens if you move the funds to an IRA prior to year end and before the refund is dispersed back to you?

  10. David

    It’s not just the tax deferred money that’s involved here. The employer match is completely taken away as well. That’s not money I can re-invest or spend. That’s a documented company benefit that was removed based on other’s lack of participation.

  11. Jeff

    I agree with most of the comments above regarding the reverse-fairness of the HCE law. Its hard to define the intent of this law as anything other than socialist-policy enforcement via tax law. If policy was a flat contrib. amount of $17.5k as wdh suggests, that would mean equal opportunity and fairness for all. the HCE component is unfair as it is not based on one’s individual motivation and ability to earn, but based on the (in) actions of others. Unfortunate I will have to evaluate the application of this policy carefully prior to taking a job with any employer in the future. Oh well. The current US tax code disproportionately benefits lower-income earners anyway, so just another step in that direction, not a surprise I suppose.

  12. ryan

    This law is ridiculous. We are given an oppurtunity to invest a percentage of our income. So 7 percent of a highly compc emp is the same as 7% of lower comp. It is proportional to ones income..just as hard for me to save 7% as the next but it is an individual choice. So your telling me that because more LCe are not devoting there income to savings that the responsible ones are penalized. Well maybe that attitude is the exact reason for Hce vs Lce. The desire to plan ahead may be how HCE got there position. I decided to have a job that paid well in order to have a family and live comfortably, so i worked my tail off and got it. But now i am having to depend on others just to save for my future. Maybe while i was going to college for 6 years they should have too. Its total BS. This is socialism for sure…ive got an idea! Why dont we all make the same amt of money…contribute the same amt the same car…have the same hobbies, all make the same grades etc. Oooh bc then there would be no desire to work hard and achieve goals and or do any better than the next guy. Then the US would be just as unproducrive as the third world countries. Give me a break with this anti discrimination law…its a bunch of nonsense. Someone has to fix this for the american dream to stay alive

  13. Gremlin

    I am guessing Crash would not have been down at Boston Harbor throwing the tea overboard. He would be home not complaining and being a good loyal British subject.

  14. Mthethuvumile mpofu

    Poonka… Thank you very much. This is the best explanation I have received. My own company couldn’t explain it clearly to us. Now I understand better. My question is if everyone in the company made $115000 and contributed to 401k .In this instance, will employes be able to contribute maximum $18000 to 401k.

  15. Mthethuvumile mpofu

    Poonka… Thank you very much. This is the best explanation I have received. My own company couldn’t explain it clearly to us. Now I understand better. My question is if everyone in the company made $115000 and contributed to 401k .In this instance, will employes be able to contribute maximum $18000 to 401k.

  16. Amy

    Mthethuvumile mpofu: If there are zero non-highly compensated employees then I THINK it would pass the test. But if there is a single non-highly compensated employee that does not contribute to the plan, then NO ONE in the highly compensated group can contribute. Keep in mind that the values change. For 2015 the value is actually $120,000. I do not know if that will go up for 2016 but it seems unlikely.

  17. kat zieg

    For 2014 I happened to make more than $115k. First time ever in 6 figures for me, I have had years making $20K, $40K, all over the map but not huge. In Dec 2015 I was told that my limits were over and I would be taxed on the excess amount- $4600. I read online that had I been notified sooner- before April 15 2015- I could have corrected this.
    But here is my question: where is that money? Because Ing/Voya NEVER sent me a check for that money- if it was truly “distributed” to me, where is it? I cannot get an answer from the legal firm that sent me the letter about this. I am unhappy that it took them so long to figure this out so that I was not able to correct it. I guess the good news is, last year I didn’t make very much money so it wont be a huge tax it, but where is that money?

    • Amy

      Kat- The company that administers the plan should send you a distribution. For example, our plan is held by Fidelity. They would likely be the ones that should send you the money. The company would have submitted your contributions very soon after each paycheck. If they continued to take money out and later notified you that you paid too much into the plan, then the plan admin would have the money. They should have sent it at year end when it was determined. Call the 401k company and they should have it. I am surprised the benefits coordinator cannot answer this question. Good luck! Let us know how it turns out.

  18. JB

    It’s not fair that those that “can” contribute are not, penalizing those that want to. There should be at least a mandatory 2% contribution.

  19. Wack

    That is why we need to remove employer from retirement savings. Allow every employee an option of SEPA (of something similar to self employed person). Let employee contribute to that account from payroll and employer can also contribute to that account if willing.

  20. Mark M

    I have found myself in a similar over-contributed situation for 2015. And I have already rolled over this contribution into an IRA as I no longer work at the company that failed the non-discrimination tests. So I know I have to get the overage out of the IRA by the tax deadline. But am I legally obligated to return the company match (overage portion) to my former employer?

  21. langsep Lee

    Does the HCE income limit different for each company? I make less than IRS definition of being a highly compensated employee, but above average of other employees at the company. The HR manager sent me a letter that said I can only contribute less than 5% of my salary so company won’t fail the test. Is the benefit I receive counted as income too, such as free health insurance?

  22. TaxitionWithoutRepresentation

    For years, I’ve maxed out my 401k to the IRS limit $18000 even when I made much less. But I now have a much lower limit than IRS because I am a HCE. The company only matches the first 2%. So it’s not like if I contribute more, I will get more or the company will pay more. My company limits HCE at 10%. This really just hurts those barely above HCE limit ($120k). If you are below it, you can contribute up to $18k. If you are just over $120k, you can only contribute $12k. The real highly compensated employees who make over $180k won’t be affected because they will be able to max out at IRS allowance! So this is so unfair!

  23. TW

    For years, I’ve maxed out my 401k to the IRS limit $18000 even when I made much less. But I now have a much lower limit than IRS because I am a HCE. The company only matches the first 2%. So it’s not like if I contribute more, I will get more or the company will pay more. My company limits HCE at 10%. This really just hurts those barely above HCE limit ($120k). If you are below it, you can contribute up to $18k. If you are just over $120k, you can only contribute $12k. The real highly compensated employees who make over $180k won’t be affected because they will be able to max out at IRS allowance! So this is so unfair!

  24. EJ

    This is totally unfair rule towards HCEs as they are abused by law it seems. In fact, they should be at least allowed to defer up to 18K along with other folks to make more legitimate .

    BTW, I have couple of questions:

    1. Can we invest in ROTH IRA account for the remaining amount? For example, your company is limited to defer up to 6K per year, then rest of the 12K can be deferred to ROTH IRA account?
    2. Can we invest in 529 [College fund account] towards your kid’s education for future needs?

    These are the two options that I can think of. If you come across any, please share. Thank you.

    • Bill

      Hi. Question: What happens when (1) I have contributed my maximum of $24,000 by June of the year (2017), (2) my company is bought in July of same year, (3) financial management of my 401k funds are, as a result of the merger, automatically switched from old to new financial management firm (i.e. from Principal to Merrill), (4) Principal now refunds me $5000 because of the highly compensated employee rule? Shouldn’t the determination of highly compensated employee issue be made at the end of the year–taking into consideration also the new company’s compensation factors? If not, can I contribute with my new company (and Merrill) the refunded $5000, as my original contribution is now only $19,000 rather than the permitted $24,000? If not, why not?


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