Highly Compensated Employee Identification

Posted by Maria T. Hurd, CPA 

Highly Compensated Employees - Delaware CPA Firm. In retirement plan administration, it is sometimes necessary to use prior year data to make certain determinations. Using prior year data sometimes produces results that clients find counterintuitive. One example is the identification of Highly Compensated Employees (HCEs).

For purposes of retirement plans, an HCE is:

  • any person who, during the preceding year received compensation in excess of an amount set forth in the Internal Revenue Code as annually adjusted for the cost of living. The lookback amount is $120,000 for 2015 and 2016.
  • If elected by the employer, the top 20% of employees ranked by compensation for the 12 months preceding the plan year.
  • a shareholder owning more than 5% of the voting power or value of the employer (attribution applies to spouse, children, parents or grandparents)

Because prior year compensation is used to identify HCEs, a new employee with a base salary of $500,000 is not an HCE in the first year of employment because there was no compensation in the prior year. Conversely, if an HCE contributes the maximum deferral amount of $18,000 within the first few months of the year and immediately changes jobs or retires, that HCE could have a substantially negative impact on the Actual Deferral Percentage (ADP) Test for that year.

In the first instance involving a new employee with substantial compensation, the employee could positively impact the ADP test by contributing the maximum deferral. If otherwise excludible employees are not tested separately, the contribution would improve the ADP for the Non-Highly Compensated Employee population, and thus allow the HCE population to defer more, or receive less in excess distributions, as applicable. Conversely, an employer cannot exclude from the HCE population an employee who voluntarily terminates employment prior to earning $120,000 in their final year of employment if the person’s compensation exceeded the threshold in the lookback year, making him an HCE.

Prior year compensation is not used to compute the ADP for HCEs.

It is important to note that the identification of the HCEs is a separate process from the ADP/ACP tests, which do not use prior year compensation with regard to the HCEs.  In fact, once the HCEs are identified using the criteria listed above, including prior year compensation, the ADP and the ACP for the HCEs is always determined using data from the plan year being tested. If the current year method is used, the ADP or ACP for the NHCEs is also determined using data from the plan year being tested. However, if the prior year test method is used, the ADP or ACP for the NHCEs is determined using data from the preceding year, but current year compensation is used for the HCEs.

For employers filling out their discrimination testing questionnaires, wondering if the rules still apply when the results are unwelcome or unexpected, I hope this blog has clarified that the lookback rules can cause unwelcome results on the ADP test when an HCE contributes the maximum early in the year and immediately terminates employment. Utilitarians determine whether rules are right or wrong based on the results that they produce, but in the ERISA world, the unhappiness of an employer dissatisfied with testing results are not a determining factor in establishing what data are used in the test.

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