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