Highly Compensated Employee (HCE) Rules for 2026: Definition, Testing, and Refunds

A highly compensated employee is a 5% owner or a worker who earned more than $160,000 in the lookback year, and that label decides who can lose part of a 401(k) deferral when a plan fails its nondiscrimination tests.

Written by Craig Wear, CFP® | Last reviewed: October 9, 2026

What is a highly compensated employee in 2026?

A highly compensated employee (HCE) is anyone who either owned more than 5% of the employer at any time during the current or preceding year, or earned more than the IRS compensation threshold from that employer in the preceding year. The statutory definition sits in IRC Section 414(q), and the IRS retirement plan definitions page restates it in plain language.

The label matters only inside qualified retirement plans. It does not change an individual’s tax bracket, and it does not reduce the $24,500 elective deferral limit that applies to every 401(k) participant in 2026. What it does is sort the workforce into two groups (HCEs and non-HCEs) so the plan can prove that benefits are not tilted toward the highest earners.

For HCE purposes, “compensation” follows the Section 415(c)(3) definition, which generally includes wages, bonuses, and commissions and adds back elective deferrals to a 401(k). A base salary under $160,000 can still produce HCE status once a bonus is counted.

Which year’s $160,000 threshold applies to 2026 HCE status?

For a 2026 plan year, the compensation test looks at pay earned in 2025 and compares it with the threshold tied to 2025, which is $160,000. IRS Notice 2025-67 states that the Section 414(q)(1)(B) threshold “remains $160,000,” so the same figure carries into 2026 for determinations made in 2027.

This lookback design means an employee who receives a large raise in 2026 is usually not an HCE until 2027. It also means someone whose pay fell below the threshold in 2026 may still be tested as an HCE for all of 2026 because of 2025 earnings.

The 5% owner test works differently. It is checked in both the current year and the preceding year, so a new owner becomes an HCE immediately rather than waiting a year.

How does the 5% owner rule work, and who counts through family attribution?

An employee who owns more than 5% of the business at any time during the current or preceding year is an HCE regardless of salary. Section 414(q)(2) borrows the 5% owner definition from IRC Section 416(i)(1), which counts stock, capital, or profits interests above 5%.

Ownership attribution is where plans most often misclassify people. Under the constructive ownership rules that Section 416 incorporates, an owner’s spouse, children, grandchildren, and parents are generally treated as owning the owner’s shares. A spouse or adult child on payroll at a modest salary can therefore be an HCE.

The IRS flags this exact error. Its Fix-It Guide example describes a plan that classified the child of a 5% owner as a non-HCE, reran the test with the corrected classification, and failed.

What is the top-paid group election?

The top-paid group election lets an employer treat an employee as an HCE under the compensation test only if that employee earned above the threshold and also ranked in the top 20% of employees by pay. The rule appears in Section 414(q)(3), and the plan document must specify whether the employer uses it.

The election tends to matter at firms where many employees earn above $160,000, such as law, medical, and engineering practices. Without it, a large share of staff could be HCEs, leaving a small non-HCE group to carry the test. With it, employees above the threshold but outside the top 20% are tested as non-HCEs.

When counting employees for the 20% calculation, Section 414(q)(5) lets the plan exclude certain groups, including employees under age 21, those with less than six months of service, and those who normally work fewer than 17.5 hours per week. The election does not affect 5% owners, who remain HCEs either way. Age thresholds for joining a plan are covered in how old you have to be to open a 401(k).

How do the ADP and ACP nondiscrimination tests work?

The Actual Deferral Percentage (ADP) test compares the average deferral rate of HCEs with the average deferral rate of non-HCEs, and the Actual Contribution Percentage (ACP) test does the same for matching and after-tax employee contributions. Both are described in the IRS 401(k) plan qualification requirements.

Each eligible employee’s deferral percentage is calculated as deferrals divided by compensation. Eligible employees who chose not to defer count as zero, which is why low participation among rank-and-file staff is a common cause of failure. The plan then averages the percentages within each group.

The HCE average may not exceed a ceiling tied to the non-HCE average. Per the IRS Fix-It Guide, the ceiling is the greater of 125% of the non-HCE average, or the lesser of 200% of it or the non-HCE average plus 2 percentage points.

To see the effect in dollars, consider an HCE earning $200,000 who defers the full $24,500, a rate of about 12.25%. If non-HCEs average 4%, the HCE group average is capped at 6%, so that employee’s deferral rate may need to come down unless other HCEs defer far less. Plans may run the test on a current-year or prior-year basis for the non-HCE average, as the plan document specifies.

What happens when a 401(k) fails nondiscrimination testing?

When a plan fails the ADP or ACP test, it must take the corrective action written in its plan document, most often by refunding excess contributions to HCEs or by making qualified nonelective contributions (QNECs) to non-HCEs. The IRS Fix-It Guide sets out the timing rules.

1. Two and a half months after plan year end: refunds (or recharacterizations) made by this point avoid the employer’s 10% excise tax under Section 4979. For a calendar-year plan, that is March 15. Certain eligible automatic contribution arrangements get six months.
2. Twelve months after plan year end: the plan can still distribute excess contributions, but the employer files Form 5330 and pays the 10% excise tax on late refunds. If correction is not made within the 12-month window, the cash or deferred arrangement loses qualified status and the entire plan may be at risk.
3. After 12 months: correction runs through the IRS Employee Plans Compliance Resolution System, and both methods the IRS describes require QNECs for non-HCEs.

Refunds are not spread evenly. Section 401(k)(8)(C) requires excess contributions to be distributed to HCEs “on the basis of the amount of contributions” each made, so the HCEs who deferred the most dollars are reduced first. Any matching contributions tied to refunded deferrals are forfeited.

A refund of pre-tax deferrals is taxable to the HCE in the year it is distributed, is reported on Form 1099-R, and cannot be rolled over. Section 401(k)(8)(D) exempts these corrective distributions from the 10% early withdrawal tax. For an HCE age 50 or older who has not used the catch-up limit, the plan may instead recharacterize the excess as a catch-up contribution, keeping the money in the account.

A QNEC is an employer contribution that is 100% vested immediately and subject to the same distribution restrictions as elective deferrals. Raising the non-HCE average with QNECs avoids refunds but costs the employer real dollars, which is one reason many sponsors move to a design that satisfies testing in advance. That design, the safe harbor 401(k), is explained in full in the guide to the safe harbor 401(k), and the broader menu of plan types appears in the overview of small business 401(k) options.

How is HCE status different from the Roth catch-up wage threshold and key employee rules?

HCE status, the SECURE 2.0 Roth catch-up wage threshold, and top-heavy “key employee” status are three separate tests with different measures and different consequences. Confusing them is common because all three involve high earners and all three have 2026 figures published in Notice 2025-67.

The Roth catch-up rule applies only to catch-up dollars, and only when prior-year FICA wages from that employer exceed the threshold. The requirement applies to 2026 catch-ups; the final Treasury regulations generally apply starting in 2027, and plans may follow a reasonable good-faith interpretation for 2026. The mechanics of that rule are covered in catch-up contributions for 2026, and the point that Roth 401(k) deferrals themselves have no income cap is explained in Roth 401(k) income limits.

A self-employed partner with no W-2 wages, for example, can be an HCE through ownership while falling outside the Roth catch-up wage test entirely. The top-heavy 60% test is summarized on the IRS qualification requirements page.

What planning options do HCEs consider when 401(k) deferrals are capped?

When testing limits how much an HCE can defer, the shortfall often shifts to other account types, and the choice among them is largely a question of when to pay tax. A refund of pre-tax deferrals also adds taxable income in the year it arrives, which can push the year’s total higher than planned within the 2026 federal income tax brackets.

Common alternatives include the following:

• Backdoor Roth IRA: HCE-level income usually exceeds the 2026 Roth IRA phase-out ($153,000 to $168,000 single, $242,000 to $252,000 married filing jointly), so a nondeductible contribution followed by a conversion is often discussed. Limits are covered in backdoor Roth IRA contribution limits.
• After-tax 401(k) contributions: these are tested under the ACP test, and the safe harbor exemption for matching contributions generally does not extend to them. That interaction is a key constraint for the strategy described in mega backdoor Roth for high earners.
• Nonqualified deferred compensation: NQDC plans are not subject to ADP testing and are often offered to HCEs, with tradeoffs explained in how a deferred compensation plan works.

Pre-tax balances that build up during high-earning years eventually face required minimum distributions starting at age 73 or 75. Households in this position often weigh whether lower-income years between retirement and RMD age suit partial Roth conversions, a topic covered in Roth conversion strategies for high-income earners. A financial professional can model how deferral caps, refunds, and future conversions interact for a specific household.

Frequently asked questions

Methodology: This article is built from primary sources: IRS Notice 2025-67 (2026 retirement plan limits), the text of IRC Sections 401(k), 414(q), and 416(i), the IRS 401(k) Plan Fix-It Guide on failed ADP and ACP tests, the IRS 401(k) plan qualification requirements page, and the Treasury and IRS announcement of final Roth catch-up regulations. Because retirement plan rules are a your-money-your-life topic, anonymous forum anecdotes and unsourced secondary summaries were excluded. All dollar figures reflect 2026 IRS limits.

This article is for educational purposes only and is not individualized investment, tax, or legal advice. Consult a qualified professional about your specific situation.