A highly compensated employee (HCE) in a 401(k) plan is someone the IRS singles out for extra scrutiny because they either earn above a set threshold or own a meaningful stake in the business. For the 2026 plan year, you are an HCE if you earned more than $160,000 from the employer in 2025, or if you owned more than 5% of the company at any point in 2025 or 2026.1Internal Revenue Service. Identifying Highly Compensated Employees in an Initial or Short Plan Year The label matters because it forces the plan through annual nondiscrimination testing, and a failed test can cap what HCEs actually get to defer, sometimes far below the statutory limit.
Who Counts as an HCE
Section 414(q) of the Internal Revenue Code sets two independent tests. Meeting either one is enough.
The Compensation Test
If you were paid more than $160,000 by the employer in the prior year, you’re an HCE this year. It’s a look-back rule, so your 2026 status hinges on 2025 pay, not what you’re earning now.2Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions The $160,000 figure is inflation-adjusted periodically and holds steady from 2025 into 2026.
Employers can shrink the HCE pool by adding a “top-paid group election” to the plan document. Under that election, only employees who both clear $160,000 and rank in the top 20% by pay count as HCEs. Without it, everyone over the threshold is in.
The Ownership Test
Own more than 5% of the business at any point in the current or prior year and you are an HCE, regardless of what you’re paid.3Internal Revenue Service. Retirement Plans Definitions A founder drawing a modest salary still qualifies.
Family ownership can pull you across the line too. Attribution rules treat certain relatives’ shares as yours. If your spouse owns 4% and you own 2%, the IRS treats you as a 6% owner and an HCE under this test.4Office of the Law Revision Counsel. 26 USC 414 – Definitions and Special Rules
Why the Label Restricts Your 401(k)
The classification exists so plans don’t end up as tax shelters for executives and owners while the rest of the workforce ignores them. Every year the plan runs two tests that compare HCEs to non-highly compensated employees (NHCEs): the Actual Deferral Percentage (ADP) test looks at employee salary deferrals, and the Actual Contribution Percentage (ACP) test looks at employer match and after-tax employee contributions.5Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
Both tests use the same formula. The HCE group’s average passes if it stays under the greater of:
- 125% of the NHCE average, or
- The NHCE average plus 2 percentage points, but no more than double the NHCE average.
What that means in practice: if NHCEs average a 6% deferral rate, HCEs can average up to 8%. If NHCEs average only 2%, the doubling cap pulls HCEs down to 4%. When rank-and-file participation is weak, HCEs get squeezed hard, no matter what the statutory contribution limit says.
What Happens When the Plan Fails Its Test
If HCE deferrals push the average past the ceiling, the plan is out of compliance and the employer has to fix it. The most direct fix is a corrective refund: the plan calculates how much the HCE group exceeded the limit, then returns that excess, adjusted for investment gains or losses, to the affected HCEs.
Timing is strict. For a calendar-year plan, refunds must go out by March 15, two and a half months after year-end. Plans with an eligible automatic contribution arrangement get six months.6eCFR. 26 CFR 54.4979-1 – Excise Tax on Certain Excess Contributions Miss the deadline and the employer owes a 10% excise tax on the excess, reported on Form 5330.7Office of the Law Revision Counsel. 26 USC 4979 – Tax on Certain Excess Contributions Fail to correct within 12 months of year-end and the plan’s cash-or-deferred arrangement can lose its qualified status.5Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
How the Refund Is Taxed
If you receive a corrective refund, the returned deferral and its earnings are taxable income. The 10% early-withdrawal penalty that normally applies to pre-59½ retirement distributions does not apply to timely corrective distributions.8Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions Still, money you set aside expecting tax-deferred growth reappears months later as taxable wages. If you’re near the HCE line, ask your plan administrator whether mid-year test projections are available before you max out.
2026 Contribution Limits and What HCEs Actually Get
HCE status doesn’t change the statutory 401(k) limits. For 2026, the elective deferral limit is $24,500. Employees 50 and older can add an $8,000 catch-up for a total of $32,500. Under SECURE 2.0, employees aged 60 through 63 get a larger catch-up of $11,250, taking the maximum to $35,750.9Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026; IRA Limit Increases to $7,500
Those are ceilings, not guarantees. If the plan flunks its ADP test, your allowable deferral gets pulled back to whatever keeps the HCE average within the nondiscrimination limits. An HCE at a company where NHCEs average 2% deferrals can be capped at 4% of pay, well short of $24,500. The gap between the statutory limit and what testing actually permits is the core frustration of HCE status.2Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
The Safe Harbor Escape Hatch
Employers can skip ADP and ACP testing entirely by adopting a safe harbor 401(k). A qualifying safe harbor plan is automatically deemed to pass both tests, which means HCE deferrals are no longer capped by what everyone else contributes.10Internal Revenue Service. Chapter 7 – 401(k) Determination Issues In exchange, the employer commits to one of two contribution formulas for all eligible employees:
- A nonelective contribution of at least 3% of pay for every eligible employee, whether or not they defer, or
- A match of 100% on the first 3% of pay deferred plus 50% on the next 2%. An enhanced match is allowed if it is at least as generous at every deferral level.
All safe harbor contributions must be immediately and fully vested, and the employer must send an eligibility notice to every eligible employee between 30 and 90 days before the plan year begins.11Internal Revenue Service. Notice Requirement for a Safe Harbor 401(k) or 401(m) Plan For a small business where a few owners earn far more than the staff, safe harbor is usually the only realistic path to letting HCEs hit the full annual deferral limit.
HCE Is Not the Same as Key Employee
HCE status drives ADP and ACP testing. A separate classification, “key employee,” drives the top-heavy test, which checks whether key employees hold more than 60% of total plan assets.12Internal Revenue Service. Is My 401(k) Top-Heavy? The thresholds are different: officers earning more than $235,000 in 2026, more-than-5% owners, and more-than-1% owners earning over $150,000 (a figure that is not inflation-adjusted). The 5% ownership rule catches the same people under both classifications, which is why small business owners often trip both sets of tests at once.
If you’ve been told you’re an HCE for the coming plan year, the useful moves are practical ones: ask whether the plan is safe harbor (if yes, defer freely up to the statutory limit), ask for last year’s ADP and ACP results, and if the plan has a history of failing, plan your deferrals against the likely cap rather than the $24,500 ceiling.