The highly compensated employee definition decides which workers get measured against two separate nondiscrimination tests a small or mid-size employer runs every year. For 2026, an employee is an HCE under IRC Section 414(q) if they either earned more than $160,000 in 2025, or owned more than 5% of the business at any time during the current or preceding year. Most payroll teams first meet this classification while testing a 401(k) plan, then never realize the identical roster also feeds their Section 125 cafeteria plan testing. Here is how the 2026 thresholds work and where the two tests HCE status feeds most often get confused.
If you have not yet built out a Section 125 plan, start with our Section 125 cafeteria plan 2026 guide for the foundation, then come back here to see how HCE status affects it.
What Is a Highly Compensated Employee Under Federal Tax Law?
A highly compensated employee is a worker who meets either of two independent tests under IRC Section 414(q): a compensation test based on prior-year pay above an indexed dollar threshold, or an ownership test based on owning more than 5% of the business at any time during the current or preceding year. An employee only has to satisfy one of the two tests to be an HCE, and satisfying both does not create a stronger or different classification, since HCE status itself is a single binary label. Congress wrote the HCE definition for 401(k) and other retirement plan testing, and Section 125(e) later imported the identical definition for cafeteria plan nondiscrimination testing rather than writing a separate compensation rule from scratch.
How Much Do You Have to Earn to Be an HCE in 2026?
An employee is an HCE under the compensation test if their prior-year pay exceeded $160,000, the 2026 threshold confirmed in IRS Notice 2025-67. This figure adjusts for inflation in $5,000 increments, and 2026 is the first year in several consecutive cycles the number did not move up, since cumulative inflation had not yet crossed the next rounding point. The test runs on a lookback year, so 2025 W-2 compensation determines 2026 HCE status, not current-year pay still being earned. An employee who first crosses $160,000 during 2026 does not become an HCE until the 2027 plan year, once that higher pay becomes the lookback year.
| Threshold | 2025 amount | 2026 amount | Change |
|---|---|---|---|
| HCE compensation test (IRC §414(q)) | $160,000 | $160,000 | No change |
| Key employee officer test (IRC §416(i)) | $230,000 | $235,000 | +$5,000 |
| Key employee 1% owner test (IRC §416(i)) | $150,000 | $150,000 | Fixed, never indexed |
Does Owning Part of the Business Make You an HCE?
Yes. A person who owned more than 5% of the business at any time during the current plan year or the immediately preceding year is an HCE under IRC Section 414(q)(1)(A), regardless of how much or how little compensation they actually received. This ownership test reaches stock or capital interest attributed from a spouse, child, parent, or grandparent, the same attribution rules used for the separate key employee ownership test. The two-year lookback window is wider than the single-year determination most other benefit ownership tests use, so a person who sold down from 7% to 3% ownership last year is still an HCE this year purely because of where their stake stood twelve months earlier.
What Is the Top-Paid Group Election?
The top-paid group election under IRC Section 414(q)(1)(B)(ii) lets an employer limit HCE status among employees who clear the compensation threshold to only the top 20% of the workforce by pay, instead of treating everyone above $160,000 as an HCE automatically. A 200-employee company where 55 people earn above $160,000 could, with this election on file, classify only the top 40 earners, the top 20% of the full workforce, as HCEs under the compensation prong. The election has no effect on the ownership test, so a 6% owner earning $95,000 stays an HCE regardless of pay rank, and once adopted the election must be documented in the plan and applied consistently.
Is a Highly Compensated Employee the Same as a Key Employee?
No. A key employee is defined under a separate statute, IRC Section 416(i), requiring an officer title paired with pay above $235,000 for 2026, a more-than-5% ownership stake at any pay level, or a more-than-1% stake paired with pay above a fixed $150,000. Every key employee automatically satisfies the HCE definition too, but the reverse is not true. A well-paid engineer earning $175,000 with no officer title and no ownership stake is an HCE for every test that uses the HCE definition, yet is never a key employee, and the two labels drive different compliance obligations across the same benefits program.
How Does HCE Status Affect a Section 125 Cafeteria Plan?
HCE status feeds two separate Section 125 tests. The eligibility test under Section 125(b)(1) checks whether the plan discriminates in favor of highly compensated individuals in who is allowed to participate, looking at waiting periods and job classifications rather than dollar amounts. The benefits test under Section 125(b)(2) compares the average nontaxable benefits highly compensated participants actually receive against everyone else in the plan. A plan can offer identical enrollment terms to every employee and still fail the benefits test if HCEs simply elect richer benefits at a higher average dollar amount. This is a different measurement than the 25% key employee concentration test covered in our nondiscrimination testing guide, which only looks at the narrower key employee group, so a plan can fail the HCE benefits test while still passing the key employee concentration test cleanly.
A 90-employee company with 18 HCEs electing an average of $9,200 a year against 72 non-HCEs averaging $5,100 has roughly an 80% gap between the two groups, the kind of disparity that draws scrutiny during annual testing even when every employee had identical access to the plan.
Does HCE Status Affect a 401(k) Plan?
Yes. Under IRC Section 401(k)(3), the Actual Deferral Percentage test caps how much more HCEs can defer on average compared to non-HCEs, generally the lesser of the non-HCE average plus 2 percentage points or twice the non-HCE average. A plan that fails this test must refund excess HCE contributions, which creates taxable income for those employees, or make an additional contribution to non-HCEs to close the gap. Passing the 401(k) ADP test does not mean a company's Section 125 plan is automatically fine too, since the two tests use the identical HCE roster but measure entirely different benefits with different math.
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Frequently Asked Questions
What is a highly compensated employee under federal tax law?
What is the HCE compensation threshold for 2026?
Does the HCE threshold use this year's pay or last year's pay?
Is every 5% owner automatically an HCE?
Is a highly compensated employee the same as a key employee?
How does HCE status affect a Section 125 cafeteria plan?
Does HCE status affect a 401(k) plan?
Can a new hire be an HCE in their first year?
Not sure which of your employees actually count as HCEs for 2026? Summit Health Benefits builds the determination once and checks it against your Section 125 eligibility test, benefits test, and 401(k) ADP test.
See Your Plan OptionsSources: Internal Revenue Code Sections 125, 401, 414, and 416; IRS Notice 2025-67; Internal Revenue Service Publication 15-B.