The ERISA consultants at the Learning Center Resource Desk, which is available through Columbia Threadneedle Investments, regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with an advisor in California is representative of a common inquiry related to determining highly compensated employees (HCEs). The advisor asked:
“What definition of compensation is used to determine who is considered an HCE for nondiscrimination testing in a 401(k) plan?”
- 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.
The Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC (RLC), a third-party industry consultant that is not affiliated with Columbia Threadneedle. Any information provided is for informational purposes only. It cannot be used for the purposes of avoiding penalties and taxes.
Columbia Threadneedle does not provide tax or legal advice. Consumers consult with their tax advisor or attorney regarding their specific situation.
Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Columbia Threadneedle.
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