What are the rules for 401(k) contributions as a highly compensated employee?

Summary 

What is a highly compensated employee (HCE)? 

According to the IRS, a highly compensated employee or “key employee” is an employee who meets certain earning criteria.  

An HCE must make over $225,000 in 2024 to qualify. Owners must also hold over 5% of their capital or stock, and earners who earn more than $155,000 in 2024 (not adjusted for inflation) and hold over 1% of shares or capital also qualify. 

The 2024 highly compensated employee limit for deductions and contributions stands at $345,000. The compensation covers recurring salaries from an employer and commissions, overtime payments, bonuses, and salary deferrals made towards 401(k)s and cafeteria plans.  

The IRS also states that your employer can designate you as a highly compensated employee if you rank among the leading 20% of employees in compensation value.  

The 5% mentioned above rule states that 401(k) plan holders who own more than 5% are required to begin required minimum distributions (RMDs) by April 1 of the first year after the year in which the plan participant turns 73 years old.  

The highly compensated employee exemption rule is based on company share values but also takes into account ownership of any spouses, children and grandchildren who work for the same company. This means that if you hold 4% in your company and your spouse holds 2% in the same firm, you will exceed the 5% limit and be classified as an HCE.

What are the contribution limits and restrictions for HCEs? 

In 2024, any 401k highly compensated employee’s single filing can contribute up to a maximum of $23,000.  

Employees aged 50 and up can contribute an extra $7,500 in “catch-up” contributions, with total employee contributions limited to $30,500 in the current year. The 2024 highly compensated employee limit, including employer and employee contributions, is $69,000 for employees under 50 and $76,500 for employees aged 50+. 

401(k) plans must pass annual non-discrimination tests to ensure that HCEs do not disproportionately benefit and that the IRS’s stipulated contribution limits are not exceeded.  

A Third Party Administrator usually conducts these tests to ensure that tax deduction deadlines are met. 

What is non-discrimination testing, and why is it important? 

A non-discrimination 401 (k) highly compensated employee test must be passed to show that annual 401(k) contributions do not discriminate against highly compensated employees.  

The Actual Deferral Percentage (ADP) test demonstrates the rate of salary deferrals, including Roth and pre-tax deferrals but not including catch-ups, to ensure that deferrals made to HCEs during the year did not exceed the specified non-HCE rate. 

Actual Contribution Percentage (ACP) tests demonstrate the rate of matching and voluntary post-tax contributions to HCEs made throughout the year did not exceed the non-HCE rate by the specified amount. 

The most widely used ADP correction method is refunding contributions made to HCEs in the amount needed to pass the ADP test. Refunds made after March 15, 2024, will be subject to a 10% excise tax. The ACP test uses the same correction method. 

5 strategies to maximize 401(k) contributions as an HCE 

Use these strategies to maximize your HCE 401(k) contributions and increase your retirement savings as a highly compensated employee. 

How do I manage my taxes as an HCE? 

Maximizing your 401(k) contributions is important to increase your retirement nest egg, but exploring alternative retirement vehicles that can supplement your savings is essential.  

Options like a Traditional IRA allow HCEs to make non-deductible contributions to increase their 401(k) savings, allowing individuals to benefit from tax-deferred investment growth. 

Roth IRAs are another option that uses after-tax dollars. Although they do not provide immediate benefits, they can offer notable long-term advantages, as withdrawals made after five years are completely tax-free. If you earn in excess of the Roth IRA income limit of $161,000 in 2024, you can also consider a Backdoor Roth IRA to reduce your tax burden and maximize your savings. 

Comprehensive financial planning is vital to take advantage of the potential tax benefits of deferred compensation.  

What do I do if you max out my 401(k) contributions? 

As a 401k highly compensated employee who maxed out your contributions in the previous year, you might not be aware if your company failed its top-heavy test until the next year.  

This means that your firm may refund you the excess contributions you paid. The refund will be considered taxable income and will increase your tax liabilities. 

It is recommended that you put aside some cash to cover potential tax hikes or make an estimated tax payment. Try to avoid reaching your 401(k) maximum limit until you are sure of whether or not you will encounter restrictions. 

What other retirement accounts are suitable for HCE? 

There are several other retirement savings accounts suitable for HCEs. They include: 

Non-deductible contributions to a Traditional IRA 

If you are an HCE covered by an employer retirement plan, you may not be eligible to make tax-deductible Traditional IRA contributions. The IRA deduction benefit will be phased out when your modified adjusted gross income reaches $87,000 in 2024 (or $143,000 if married and filing jointly). 

An alternative is to open a Traditional IRA, which grows your savings tax-deferred and still allows you to contribute towards the full IRA contribution limit. In 2024, the highly compensated employee limit stands at $7,000 for people aged 50 and up and $8,000 for people aged 50 and up. 

Roth IRA 

Roth IRAs are funded with after-tax dollars and enable your money to grow tax-free. In 2024, you can contribute in part to a Roth IRA as long as your earnings do not exceed $161,000 as a single filer or $240,000 filed jointly.  

Although this option has income limits, it still offers tax benefits, including tax-free retirement withdrawals after five years. 

Backdoor Roth IRA 

HCEs may also use a Backdoor Roth IRA, which converts a non-deductible IRA into a Roth IRA. The process begins with opening a Traditional IRA and a Roth IRA at the same time and then contributing the maximum to the Traditional IRA.  

Next, you will convert the Traditional IRA to a Roth IRA and pay the income taxes owed. This will allow you to make maximum tax-deferred contributions that can be withdrawn tax-free. 

Health Savings Account (HSA) 

If you have a high deductible health plan, you may be able to open a health savings account to save for future medical expenses. These accounts are funded with pre-tax dollars, and earnings are protected from tax. Savings can also be invested in securities like bonds, stocks and mutual funds and withdrawn tax-free as long as they cover qualifying medical expenses. 

Taxable accounts 

Options like securities, mutual funds and brokerage accounts are taxable investments which can supplement your retirement savings fund, regardless of your earnings. 

Get expert financial advice 

Highly compensated employees can benefit from highly compensated employee 401k plans. However, specific contribution limits and plan restrictions affect savings and ROI, so that other options may be a better choice.   

Find a financial advisor via Unbiased for expert financial advice to learn more about planning for your retirement.