Who Is a Highly Compensated Employee Under 414(q)(1)(B)?

Under Internal Revenue Code Section 414(q), a highly compensated employee (HCE) is anyone who owned more than 5% of the employer at any time during the current or preceding year, or who earned more than the indexed compensation threshold from the employer during the preceding year. For 2026 plan years, that threshold is $160,000, measured against what the employee earned in 2025.¹ The label has nothing to do with job title, seniority, or management status. It exists so the IRS can police nondiscrimination in retirement plans and stop those plans from concentrating benefits on the top of the payroll.

The Two Tests

Section 414(q) sets out two independent paths. An employee who meets either one is an HCE for the plan year in question.²

The ownership test looks at whether the employee held more than 5% of the employer at any point during the current plan year or the preceding year. The compensation test looks at whether the employee’s pay from the employer exceeded the indexed dollar threshold during the preceding year, called the look-back year. For a calendar-year plan, the look-back year is simply the prior calendar year.

Because the compensation test uses last year’s pay, plan administrators know before the plan year begins who qualifies as an HCE. That advance identification is what makes it possible to run contribution testing without waiting on year-end data.

The 5% Ownership Test

The ownership prong is absolute. Cross 5% at any point in the current year or the look-back year and you are an HCE, even if your paycheck is nothing to write home about. For a corporation, the measure is more than 5% of outstanding stock or its total value. For a partnership or LLC, it is more than 5% of the capital or profits interest.

An employee who personally owns no shares can still land on the wrong side of this line through the constructive ownership rules of Section 318. Stock held by a spouse, children, grandchildren, or parents is attributed to the employee.³ If your father owns 6% of the company you work for, you are treated as a 5% owner and classified as an HCE regardless of what you earn. The attribution runs through both the current and look-back years, so a brief transfer of shares out of the family during the testing window does not escape it.

The Compensation Test

The second path compares each employee’s look-back year pay against an indexed dollar figure. The $160,000 threshold that applies to 2026 plan years is unchanged from 2025.⁴

What counts as compensation is broader than base salary. Section 414(q) borrows the definition from Section 415(c)(3), which captures all W-2 wages plus certain pre-tax amounts that never appear in take-home pay.² Elective deferrals to a 401(k), 403(b), or similar plan (including Roth contributions) are added back in. So are pre-tax deductions under a Section 125 cafeteria plan for health insurance, dependent care, and similar benefits.

The gap matters. An employee whose W-2 Box 1 shows $148,000 can still clear the $160,000 threshold once you add back, say, $14,000 in 401(k) deferrals and $5,000 in pre-tax health premiums.⁵ Administrators who look only at Box 1 instead of full Section 415 compensation will misclassify people, and the error carries into every nondiscrimination test the plan runs.

The Top-Paid Group Election

Employers can layer a second requirement onto the compensation test. Under the top-paid group election, an employee is an HCE under this prong only if they both cleared the $160,000 threshold and ranked in the top 20% of the workforce by pay.² The election is useful at companies where many employees earn over the threshold: shrinking the HCE group makes nondiscrimination tests easier to pass. It must be applied consistently across all of the employer’s qualified plans for the plan year.

When calculating the top 20%, the employer can exclude several categories from the total headcount, including employees with less than six months of service, those who work fewer than 17.5 hours per week, seasonal employees, those under age 21, nonresident aliens with no U.S.-source earned income, and most collectively bargained employees.² The employer can also choose stricter thresholds than the statute lists, provided the choice is applied consistently.⁶ These exclusions only shrink the headcount used to size the top 20%. They do not shield any excluded employee from HCE status if that employee independently meets the ownership test or the compensation threshold.

Former Employees

HCE status does not end at separation. A former employee remains an HCE if they were one in the year they left the company, or if they were an HCE at any point after reaching age 55.² Because former employees with remaining plan balances are still counted in nondiscrimination testing, a retired executive with a large 401(k) balance cannot shed HCE treatment simply by leaving the payroll.

Why the Classification Matters

The whole point of the definition is nondiscrimination testing. A 401(k) plan gets its tax advantages only if benefits are shared proportionally between HCEs and non-highly compensated employees (NHCEs). Two annual tests enforce that: the Actual Deferral Percentage (ADP) test on elective deferrals, and the Actual Contribution Percentage (ACP) test on employer matches and after-tax contributions. Each compares the HCE group’s average against the NHCE group’s average, and the HCE average cannot pull too far ahead.⁷

When a plan fails, the plan sponsor has 12 months after the close of the plan year to correct the failure and preserve qualified status. The usual fix is refunding excess contributions to HCEs so their average drops to a passing level. The employer can also make qualified nonelective contributions to NHCEs to lift the other side of the ratio. Corrections made within two and a half months after year-end avoid the excise tax; plans with an eligible automatic contribution arrangement get six months. After that window, the employer owes a 10% excise tax on the uncorrected amount, reported on Form 5330.⁸ Miss the 12-month deadline entirely and the plan risks losing its qualified status.

The practical consequence for individual HCEs is that testing failures can force refunds of their own contributions after year-end, cutting into what actually stays in the plan. The statutory deferral limits (24,500 for 2026, plus catch-ups for eligible ages) apply equally to HCEs and NHCEs on paper.⁹ The real ceiling for an HCE is whatever amount lets the plan pass ADP and ACP testing.

Safe Harbor as a Way Around It

Many employers sidestep testing by adopting a safe harbor 401(k) design. In exchange for committing to specific minimum employer contributions, the plan is treated as automatically satisfying nondiscrimination requirements, and HCEs can generally defer up to the full annual limit without worrying about refunds.¹⁰ The standard designs are a basic match (100% on the first 3% of pay deferred, plus 50% on the next 2%), an enhanced match at least as generous at every tier, or a nonelective contribution of at least 3% of pay for all eligible employees regardless of whether they defer. Safe harbor contributions must vest immediately, with a limited exception for certain QACA designs. If you work at a smaller company and you’re being told you can’t defer as much as your coworkers, the reason usually traces back to a plan that runs testing rather than using safe harbor.

1
Internal Revenue Service. Amounts Relating to Retirement Plans and IRAs, as Adjusted for Changes in Cost-of-Living
2
Office of the Law Revision Counsel. 26 USC 414 – Definitions and Special Rules
3
Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
4
Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
5
Office of the Law Revision Counsel. 26 USC 415 – Limitations on Benefits and Contribution Under Qualified Plans
6
eCFR. 26 CFR 1.414(q)-1T – Highly Compensated Employee (Temporary)
7
Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
8
Office of the Law Revision Counsel. 26 USC 4979 – Tax on Certain Excess Contributions
9
Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026; IRA Limit Increases to $7,500
10
Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Does Not Satisfy the 401(k) 401(k) Nondiscrimination Testing Requirements