The IRS defines highly compensated employees (HCEs) using two tests: a compensation test and an ownership test. Knowing who qualifies as an HCE — and providing accurate data — is essential to keeping your 401(k) plan compliant.
Each year, the IRS requires 401(k) plans to undergo nondiscrimination testing to make sure a retirement plan does not disproportionately benefit certain employees. Nondiscrimination tests (with the exception of the top-heavy test) divide employees into two groups: highly compensated employees (HCEs) and non-highly compensated employees (NHCEs).
Because these terms come up often in 401(k) plan administration, it is important to understand the difference — and why providing accurate compensation, ownership, and relationship information is crucial to keeping your plan compliant.
An employee is generally considered an HCE for a given year if they meet either of these criteria:
The compensation test — earned more than the HCE compensation limit in the prior year. The 2025 limit (used in 2026) is $160,000. The 2026 limit (used in 2027) is also $160,000.
The ownership test — owned more than 5% of the company at any time in either the prior or current year.
An NHCE is anyone who does not meet the compensation or ownership thresholds above.
Because there are nuances to making these determinations, each criterion is discussed further below. The examples in this article are based on calendar-year plans, as all Gusto Retirement plans operate on a calendar-year basis.
When determining who is an HCE due to compensation, always look at compensation for the prior year. This means that to be considered an HCE for 2026, an employee needs to have earned more than $160,000 in 2025.
This includes compensation earned for the full year, regardless of when the individual entered the plan. If an employee was not employed by the company in the prior year, they will not be an HCE due to compensation in the current year, regardless of their pay in the current year.
The compensation used for HCE determination can be affected if the employer is a member of a legally related group. If an employee gets compensation from more than one member of a legally related group, you need to combine all compensation when determining HCE status.
Example: Bad Wolf Inc. and Ood Industries are members of a legally related group, each sponsoring their own retirement plan. In 2025, Donna Noble received $75,000 from Bad Wolf and $90,000 from Ood Industries. When determining if she is an HCE due to compensation for 2026, compensation from both employers is added together ($165,000). Donna would be an HCE for both plans for 2026.
Employers with a large percentage of employees earning over the HCE compensation limit may benefit from using the top-paid group election.
Note: The top-paid group election is the default for Gusto Retirement plans, although it is not required.
The top-paid group election allows the plan to limit the number of employees determined to be HCEs through the compensation test to only 20% of total employees.
To determine who falls within the top-paid group, follow these steps:
Calculate 20% of all employees who are at least 21 years old and have worked at the company for at least six months. If the result is not a whole number, round up.
List employees in order of their compensation, from highest to lowest.
Starting with the highest-compensated individual, count down the list until you reach the number calculated in step 1, or until you have included all HCEs defined by compensation — whichever comes first.
Example: Bad Wolf Inc. had 13 employees over the age of 21 and employed for at least six months, and the top-paid group election is enabled for their plan. As a result, HCEs are limited to three employees (13 × 0.2 = 2.6, rounded up to 3).
An individual is an HCE due to ownership if at any time during the current or prior year they owned, or are deemed to own, more than 5% of the company. Ownership includes stock options and restricted stock. There is no compensation threshold associated with being an HCE due to ownership, and the top-paid group election does not affect this outcome.
Example: Bad Wolf Inc. is owned by seven of its employees. However, only five of them own more than 5% of the company. Therefore, only those five are HCEs due to ownership.
The ownership test can also be affected if the employer is a member of a legally related group. If an employee owns, or is deemed to own, more than 5% of any member of the legally related group, they will be an HCE due to ownership for all members of the legally related group.
When looking at the HCE ownership test, it is important to know if any employees are related to those with an ownership interest in the company, as the family attribution rules apply. In general, if an employee is the spouse, child, parent, or grandparent of an HCE by ownership, they are also an HCE by ownership.