Tag Archive for: HCE

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“What is the ’20 percent rule’ when defining highly compensated employees?”

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“I’m familiar with the IRS’s standard definition of highly compensated employee (HCE) for retirement plans, but recently I overheard another advisor talk about applying the “20 percent rule” when determining HCEs for plan purposes. What is the 20 percent rule?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with an advisor in New Jersey addressed a question on the definition of highly compensated employee (HCE).

Highlights of the Discussion

In lieu of using the IRS’s standard definition of HCE, a plan sponsor has the option of applying the 20 percent rule, otherwise known as a “Top Paid Group” election. This election allows the plan to limit the number of HCEs based on compensation to only those who are in the top 20 percent of all employees when ranked by pay.

Employers with many HCEs as determined under the standard definition of HCE, sometimes make Top Paid Group elections to limit the overall number of HCEs for plan testing purposes if the election will help them satisfy nondiscrimination requirements. Plan sponsors should work with their TPAs and recordkeepers to determine if a Top Paid Group election makes sense for their plans.

The definition of HCE for a plan is contained in the governing plan document. Generally, under IRC Sec. 414(q)(1), an HCE for a plan is a participant who either

1. Owns more than five percent of the company at any time during the current year, or the immediately preceding year; or
2. Received compensation exceeding the IRS-prescribed limit for the immediately preceding year (look back) ($130,000 for 2021 and $135,000 for 2022). [See IRC Sec. 414(q)(1)(A) and (B)]

Under the Top Paid Group election [IRC Sec. 414(q)(1)(B)(ii)], a plan participant is an HCE if he or she

• Earns over the income limit for the look-back year (as mentioned above) and
• Is within the top 20 percent of all individuals at the company when they are ranked by compensation during the look-back year.

More than 5% owners would also be HCEs if a Top Paid Group election is made.

A Very Simple Example:
Participant   % Owner   Look-Back Comp   HCE Standard   HCE Top Paid Group
Alpha            50               $750,000                Yes                        Yes
Bravo              0               $650,000                Yes                        Yes
Charlie           0               $600,000                Yes                         No
Delta              0               $130,000                 Yes                         No
Echo             50                $125,000                Yes                        Yes
Foxtrot           0                $  95,000                 No                        No
Golf                0                $  60,000                  No                        No
Hotel              0                 $   45,000                No                        No
India               0                $   35,000                 No                        No
Juliet              0                $   30,000                 No                        No

As the chart illustrates, under the standard HCE definition, HTK Inc., has five HCEs (i.e., Alpha, Bravo, Charlie, Delta and Echo). If HTK Inc., makes a Top Paid Group election, there are three HCEs (i.e., Alpha, Bravo and Echo). Charlie and Delta are no longer considered HCEs because they are not in the top-paid group, and they do not own more than 5% of HTK.

Conclusion

HCEs in a plan can be determined under the IRS’s standard or Top Paid Group definition. Plan sponsors should always check the terms of their plan document to see which definition applies, and work with their TPAs and recordkeepers to ensure proper application.

 

 

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The “High 25” and Benefit Restrictions

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The “High 25” and Benefit Restrictions

“My client, a senior partner with an engineering firm, called and was upset because the administrator of his firm’s cash balance plan told him he can’t take a lump distribution, even though the plan document specifically permits lump sums. How can this be? I thought the plan sponsor had to follow the plan document.”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • Unfortunately for your client, in certain circumstances, defined benefit (including cash balance) plans, cannot make lump sum distributions to highly compensated employees (HCEs), despite the option being available under the terms of the plan.  This restriction, sometimes known as the “High 25” or claw back rule, affects the top 25 highest paid HCEs. The rule is intended to ensure large lump sum distributions made to the top HCEs don’t jeopardize the funding status of the plan and its ability to make benefit payments to other participants.
  • Treas. Reg. 1.401(a)(4)-5(b)(3)(ii) states that a plan cannot make certain benefit payments (including a lump sum payment) to an HCE (a restricted employee) who is in the top 25 of employees in terms of compensation unless one of the following is satisfied:

 

  1. After taking into account the payment to the restricted employee of all benefits payable to or on behalf of that restricted employee under the plan, the value of plan assets must equal or exceed 110 percent of the value of current liabilities;
  2. The value of the benefits payable to or on behalf of the restricted employee must be less than one percent of the value of current liabilities before distribution; or
  3. The value of the benefits payable to the restricted employee must not exceed $5,000 [the amount described in section 411(a)(11)(A) of the Internal Revenue Code (IRC) related to restrictions on certain mandatory distributions].

 

  • Revenue Ruling 92-76 prescribes three workarounds, permitting a lump sum if the client does not wish to take an annuity payment.  A  lump sum is permitted if

 

  1. The distribution is placed in an escrow account;
  2. A surety bond is obtained for the distributed amount; or
  3. A letter of credit is secured that allows the plan to recoup all or a portion of the distribution in the event of future funding shortfall.

These rules are complex and expert counsel is necessary to ensure compliance.

Conclusion

When discussing benefit restriction rules for defined benefit plans with your clients, do not forget the well-entrenched benefit restrictions that may apply for the High 25 HCEs in the plan.

 

 

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What is the Definition of Compensation for HCEs

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What is the definition of compensation for determining HCEs?

“What definition of compensation is used to determine who is considered an HCE for nondiscrimination testing in a 401(k) plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

A plan must use an Internal Revenue Code Section (IRC §) 415 definition of compensation when determining which employees are HCEs under IRC §414(q).

  • More specifically, according to  Temporary Treasury Regulation 1.414(q)-1T, Q&A 13, the term “compensation” for HCE determination means compensation within the meaning of IRC §415(c)(3) without regard to §§125, 402(a)(8), and 402(h)(1)(B) and, in the case of employer contributions made pursuant to a salary reduction agreement, without regard to § 403(b). Thus, compensation for this purpose includes elective or salary reduction contributions to a cafeteria plan, cash or deferred arrangement or tax-sheltered annuity.

 

  • Only compensation an employee received during the “applicable period” is considered in determining HCE status.  HCE status based on compensation (not on ownership) is determined using compensation earned during the preceding year or 12-month period, referred to as the “look-back year.” If the year for which HCE status is being determined is not a calendar year, the sponsor may make a calendar year election so that HCE status is determined based on compensation earned during the calendar year beginning with or within the look-back year.

 

  • A compensation threshold applies for determining HCE status. This amount is subject to indexing.  When the amount is indexed, the new dollar amount applies to the year in which the compensation is earned, not the year in which HCE status is determined.  For example, when determining HCE status for 2017 based on compensation, plans must use the indexed amount for 2016, which was $120,000.  When determining HCE status for 2018 based on compensation, plans must use the indexed amount for 2017, which is $120,000.

Conclusion

Plans must follow a specific definition of compensation as defined in the IRC and supporting Treasury regulations when determining whether an employee is or is not an HCE.

 

© Copyright 2024 Retirement Learning Center, all rights reserved