Each year, the IRS requires 401(k) plans to undergo nondiscrimination testing to make sure that a retirement plan does not disproportionately benefit certain employees. Nondiscrimination tests (with the exception of the Top-Heavy test) divide employees into 2 groups: highly compensated employees (HCEs) and non-highly compensated employees (NHCEs).
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Because these terms are used often in administering a 401(k) plan, it is important to understand the difference and why providing accurate compensation, ownership, and relationship information is crucial to keep your plan compliant.

In general, an individual is considered an HCE for a given year if they either meet:

A NHCE is simply anyone who is not determined to be an HCE.
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Because there are nuances to making these determinations, each of the criteria will be discussed further below. Each example will be based on calendar-plan years, as all Guideline plans operate on a calendar-year basis.
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When deciding who is an HCE due to compensation, we always look at the compensation for the prior year. This means that to be considered an HCE for 2023, an employee must have earned more than $135,000 in 2022.
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Note this will include compensation earned for the full year, regardless of when the individual entered the plan. Additionally, if they were not employed by the company the prior year, they will not be an HCE due to compensation in the current year, regardless of their pay in the current year.
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As with most nondiscrimination testing issues, the compensation used for HCE determination can be affected if the employer is a member of a legally related group. If an employee receives compensation from more than one member of a legally related group, you will need to combine all compensation when determining HCE status.
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​Example
Bad Wolf Inc. and Ood Industries are members of a legally related group who each sponsor their own retirement plan. In 2022, 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 2023, compensation from both employers will be added together ($165,000). Therefore, Donna would be an HCE for both plans for 2023.
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Employers that have a large percentage of employees that earn over the HCE compensation limit may benefit from using the top-paid group election. This is the default election for Guideline plans, although it is not required. The top-paid group election allows the plan to limit the number of employees determined to be HCEs via the compensation test to only 20% of the total employees.
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To determine who would be within the top-paid group, you need to first calculate the number of HCEs by compensation. To do this, take the total number of employees who are at least 21 years old and have worked at the company for at least 6 months and multiply that by 0.2 (20%). If the result is not a whole number, round up.
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Once you have that number, list the employees in order of their compensation. Then, starting with the individual with the highest compensation, count down the list until you have reached the number of employees determined above, or until you have included all HCEs defined by compensation, whichever happens first.
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​Example
Bad Wolf Inc. had 13 employees over the age of 21 and employed for at least 6 months as of the end of 2022, and the top-paid group election is enabled for their plan.
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For 2023, HCEs due to compensation will be limited to just 3 employees (13 x 0.2 = 2.6). The chart below shows which employees of Bad Wolf Inc. are considered HCEs due to compensation using the standard definition and the top-paid group election.

An individual will be 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.
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​Example
Bad Wolf Inc. is owned by 7 of its employees. However, only 5 of them own more than 5% of the company. Therefore, only those 5 are HCEs due to ownership.
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As with the compensation test, the ownership test can 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.
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​Example
Bad Wolf Inc. and Ood Industries are members of a legally related group who each sponsor their own retirement plan. In 2022 and 2023, Donna Noble owned 10% of Bad Wolf but did not have an ownership interest in Ood Industries. When determining who is an HCE due to ownership for 2023, Donna would be an HCE for both plans, despite not having an ownership interest in Ood Industries.
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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 will 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.

Because the 2 different criteria operate fairly independently, an example may help you understand how the final HCE determination is made. Let’s look at the HCE determination for Bad Wolf Inc. and its 13 employees again, this time combining the results of both tests to determine the final list of HCEs for 2023.

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