The Downside to Being a Highly Compensated Employee

How Being Highly Compensated Can Hinder Retirement Savings

Most people don’t get the label of “Highly Compensated Employee” but if you do, there are some definite downsides, especially if you’re in the middle management phase of your career.

What is a Highly Compensated Employee

You might think that the term is a generic for those people in high places that you can only see by appointment only, but the term is actually an IRS term with a very clear-cut definition—and you’re not necessarily making an obscene amount of money.

First, you’re considered a highly compensated employee if you owned more than 5 percent of the interest in a business at any time during this year or the preceding year. Notice the “more than” part of the rule. This means that if you own exactly 5.00 percent, based on your voting power, you are not considered highly compensated but 5.01 percent puts you under that umbrella.

Also, 5 percent includes equity owned by relatives including spouse, parents, children, grandchildren. Grandparents and siblings don’t count. If you owned 3 percent and your spouse owned 2.01 percent, you are now highly compensated. In this case, it doesn’t matter how much money you made. If the business is relatively new, the owners might not draw a salary or the salary might be very little.

Second, the business paid you at least $120,000 in 2017 or 2018, and, if the employer chooses, was in the top 20 percent of employees when ranked by compensation.

You don’t have to meet both criteria to earn this label—if you’re more than a 5 percent owner but only earn $30,000 per year, you’re considered highly compensated.

How Does it Affect Me?

The highly compensated employee rules were put in place to protect those who don’t fall into this small subset of people.

In the beginning, retirement plans allowed anybody, regardless of income, to contribute a certain percentage of their income regardless of how much they made. People who made a lot of money received huge tax breaks that lower wage earners did not. This was seen as a form of discrimination, so the IRS created the highly compensated employee rules to make it fair for everybody.

The Rules

Now you’re going to see why being a highly compensated employee can be less than ideal from a 401(k) perspective. Each year, the business has to go through some tests to make sure the plan is still . One of those tests is to look at the average contribution rate of all employees.

If the average is 4 percent, most HCEs can only contribute 6 percent because highly compensated employees’ contributions cannot exceed the contributions of non-HCEs by more than 2 percent. Under this scenario, somebody making $150,000 annually can only contribute $9,000 annually—far less than the $18,500 the IRS allows. Some HCEs report only being able to contribute 2 percent because lower paid employees contribute so little.

Some workers would love to make a six-figure salary but others, especially those who live in coastal cities like San Francisco or New York City would argue that $150,000 represents a middle-class lifestyle and hurts those in middle management who need to save all the money they can for retirement.

The upper management employee making $300,000 could still almost max out their contributions at 6 percent but not the low six-figure earner.

Ways Around the HCE Rule

Your employer has some options with how they structure retirement packages but outside of that, the best thing to do is to contribute to other retirement vehicles. The easiest solution is to start an IRA and max it out. You can contribute up to $6,900 in 2018. You could also make catch up contributions if you’re over the age of 50, contribute money into taxable investment accounts, and you can still contribute to your 401(k)—you’ll just lose the tax deduction that comes with a non-Roth 401(k).

Some employers go about it another way—offer a larger employer match or if they don’t have one, institute it. For cash-strapped employees trying to make ends meet, the incentive to contribute to the plan may not be high enough without an employer match.

Along with better education of the benefits of saving for retirement and/or an employee match, experts say that getting above 50 percent participation is next to impossible—and that means a lower maximum for highly compensated employees.