Highly Compensated Individual: IRS Tests and 401(k) Consequences

For the 2026 plan year, you’re a highly compensated employee if you earned more than $160,000 during 2025 or owned more than 5% of the business at any point in 2025 or 2026.¹ The label matters because it puts your 401(k) contributions into a separate testing group each year, and if the plan’s rank-and-file participation is low, the math can force the company to cap or refund what you defer.²

The Two Ways to Qualify

IRC Section 414(q) sets out two independent tests. Meeting either one is enough.³

The Compensation Test

The compensation test looks backward. For the 2026 plan year, the threshold is $160,000, based on what you actually earned in 2025.¹ The same $160,000 figure applied for the 2025 plan year, based on 2024 pay.⁴ Because it’s always a lookback, your current-year status is fixed by history, not projections. The IRS adjusts the number for inflation in $5,000 increments.

The 5% Ownership Test

Anyone who owned more than 5% of the business at any point during the current or preceding plan year is automatically an HCE, regardless of pay.³ An owner earning $50,000 still qualifies if the stake exceeds 5%.

The ownership test also reaches people who hold no shares personally. Under the constructive ownership rules of IRC Section 318, you’re treated as owning stock held by your spouse (unless legally separated under a divorce or separate maintenance decree), your children, grandchildren, and parents.⁵ A legally adopted child counts the same as a biological one. If your spouse owns 6% of the company, you’re a more-than-5% owner even with zero shares in your own name.

When Employers Narrow the Pool: the Top-Paid Group Election

Employers with large numbers of high earners can tighten the definition using the top-paid group election under IRC Section 414(q)(1)(B)(ii). With the election in place, clearing $160,000 isn’t enough on its own. You also have to rank in the top 20% of the workforce by pay to be classified as an HCE.³

The 20% is calculated after excluding several groups from the headcount under IRC Section 414(q)(5):⁶ employees with less than six months of service, those who normally work fewer than 17½ hours per week, employees who normally work six months or less per year, workers under age 21, and employees covered by a collective bargaining agreement (with limited exceptions).

The election has to be written into the plan document, and once adopted it stays in effect until formally revoked by amendment. It’s most common at professional services firms, tech companies, and other places where a large share of the staff clears $160,000 and the employer doesn’t want half the workforce on the HCE side of the test.

What HCE Status Does to Your 401(k)

Once the plan administrator sorts employees into HCE and non-highly compensated (NHCE) groups, the plan has to pass two annual math checks: the Actual Deferral Percentage (ADP) test on elective deferrals (pre-tax and Roth) and the Actual Contribution Percentage (ACP) test on employer matches and any employee after-tax contributions.²

Both tests work the same way. The administrator figures each eligible employee’s contribution as a percentage of pay, then averages the percentages for the HCE group and the NHCE group separately. The HCE average passes if it doesn’t exceed the greater of:

125% of the NHCE average, or
the lesser of 200% of the NHCE average or the NHCE average plus 2 percentage points.

The second prong usually controls. If NHCEs average 4%, the HCE group can average up to 6%. If NHCEs average only 1%, the HCE cap drops to 2%, which is where high earners at low-participation plans get squeezed.²

Plans can measure the NHCE side using either prior-year or current-year data, and the choice sits in the plan document.² Prior-year testing gives everyone a known ceiling at the start of the year. Current-year testing tracks real deferrals but leaves the number unsettled until the year closes.

Safe Harbor Plans Skip the Test

Many employers avoid ADP and ACP testing entirely by adopting a safe harbor 401(k). A safe harbor plan is deemed to pass in exchange for a mandatory, immediately vested employer contribution.⁷ There are two main formulas:

A nonelective contribution of at least 3% of pay to every eligible employee, whether or not they defer.
A match of 100% of the first 3% of pay deferred, plus 50% of the next 2%, capping the employer contribution at 4% of pay.

Plans using a Qualified Automatic Contribution Arrangement (QACA) can use a slightly lower match formula, with a maximum required match of 3.5% of pay. Under the SECURE Act, employers using the nonelective route no longer have to send the annual safe harbor notice, but they still have to let employees change deferral elections at least once a year.⁷ If a company decides mid-year to adopt safe harbor nonelective contributions, the rate is 3% for amendments made before the plan year ends, or 4% for retroactive adoption up to 12 months after the plan year closes.

For an HCE in a safe harbor plan, the practical result is simple: you can defer up to the regular IRS elective deferral limit without worrying about a refund at year end.

What Happens When the Plan Fails the Test

If the plan doesn’t pass, the employer has to fix it, and the correction usually lands on HCE accounts.

Refunds to HCEs

The most common fix is refunding the excess deferrals to the HCEs whose contributions pushed the average too high. To avoid a 10% excise tax on the excess, these corrective distributions must be completed within 2½ months after the plan year ends. Plans with an eligible automatic contribution arrangement get six months.⁸ Miss those deadlines and the employer owes the 10% tax on Form 5330.⁹ The refunded amount, plus allocated earnings, is taxable income to you in the year you receive it.

Extra Employer Contributions to NHCEs

Instead of clawing money back from HCEs, the employer can raise the NHCE average by depositing Qualified Nonelective Contributions (QNECs) or Qualified Matching Contributions (QMACs) into non-highly compensated accounts.² QNECs and QMACs are fully vested immediately and follow the same withdrawal rules as regular elective deferrals. This path avoids uncomfortable refund conversations with executives but costs the company money.

A Different “Highly Compensated” Rule for Health and Cafeteria Plans

The $160,000 retirement rule doesn’t govern health plans. In IRC Section 105(h) for self-insured medical plans and IRC Section 125 for cafeteria plans, a “highly compensated individual” is defined separately as any of the following:¹⁰

An officer of the company.
A shareholder owning more than 5% of the voting power or value of the employer’s stock.
Someone who is “highly compensated” (generally among the top 25% of earners).
A spouse or dependent of any of the above.

Self-insured health plans can’t offer better benefits or lower contributions to highly compensated individuals under Section 105(h). If the plan fails that test, a portion of the affected individuals’ benefits becomes taxable to them. Cafeteria plans that discriminate on eligibility or benefits cause the same group to lose the tax-free treatment on their elections. Someone can be highly compensated for health-plan purposes (as an officer) without being an HCE for retirement-plan purposes (if pay is under $160,000).

HCE Is Not the Same as Key Employee

HCE status drives the ADP and ACP tests. A separate label, “key employee” under IRC Section 416, drives the top-heavy test, which checks whether key employees hold more than 60% of total plan assets. The key employee thresholds are:

More-than-5% owners (same as the HCE ownership test).
More-than-1% owners who also earn more than $150,000. This dollar figure is fixed and doesn’t adjust for inflation.
Officers earning above $230,000 for 2025 (inflation-adjusted), capped at the greater of 3 officers or 10% of employees, and never more than 50.⁴

A top-heavy plan generally has to give non-key employees a minimum contribution of 3% of pay. You can be an HCE without being a key employee, or a key employee without being an HCE, and both can apply at once.

1
Internal Revenue Service. Notice 2025-67
2
Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
3
Internal Revenue Service. Identifying Highly Compensated Employees in an Initial or Short Plan Year
4
Internal Revenue Service. Notice 2024-80 – 2025 Amounts Relating to Retirement Plans and IRAs
5
Office of the Law Revision Counsel. 26 US Code 318 – Constructive Ownership of Stock
6
Office of the Law Revision Counsel. 26 USC 414 – Definitions and Special Rules
7
Internal Revenue Service. Mid-Year Changes to Safe Harbor 401(k) Plans and Notices
8
Office of the Law Revision Counsel. 26 USC 4979 – Tax on Certain Excess Contributions
9
Internal Revenue Service. Instructions for Form 5330 (Rev. December 2025)
10
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans