The financial term “highly compensated employee” was created by the government to regulate deferred savings plans within workplaces so that executives or top earners within a business do not receive more from their retirement benefits than employees who are paid much less money. This rule would pertain to anyone who has more than 5% ownership in a company at any point during a fiscal year or someone who falls into the category of being a top 5% wage earner within that company and makes over a certain level of income. It is also important to note that highly lucrative businesses that have median incomes above this threshold are not automatically included; in these cases, only the top 5% would be considered a highly compensated employee.
Since corporations normally match a certain percentage of employee funds within a retirement account, the Internal Revenue Service (IRS) determined that the added benefit for the top earners within a company could be drastically more than what the lowest-paid employees could receive. The IRS’s reasoning behind creating a tax-deferred savings plan was to benefit all workers equally, so it was deemed unfair to allow a person making $25,000 US Dollars (USD) per year and another making $120,000 (USD) annually to both contribute the same percentage without being taxed. Before the highly compensated employee law was in effect, the higher earner in the above example was able to contribute a much higher amount per paycheck and have it 100% matched by the employer up to $16,500 (USD). Overall, the total contribution would be in excess of the lower wage earner’s total annual salary, which was not at all the basis behind creating such a program.
If a worker falls into the highly compensated employee category, his annual contribution will be limited to the average that the rest of the employees within the company were able to contribute. His total investment in the retirement program can only be 2% higher than what the average worker within the corporation contributed, and at the end of the fiscal year, the business will refund anything in excess of that amount back to the employee. From that point, those funds can either be invested in a similar type of tax-deferred savings plan or can be kept as income. If the latter route is chosen, then any applicable taxes must be paid by 15 March of the following fiscal year.
