Highly Compensated Employees

There’s one more contribution limit you might face. If you earned more than $105,000 in 2007, you are considered a highly compensated employee (HCE) for 2008. That means that the most you can contribute to your 401(k) depends on the average that all non-highly compensated employees (NHCE) either are contributing to their plans in the current year or have contributed in the previous year.

The percentage of salary that HCEs can contribute must meet one of two tests: it must either be no more than 1.25 times of the contribution rate for all NHCEs, or it must be no more than 2 times that rate and not exceed the rate by more than 2 percentage points. For example, if NHCEs contributed an average of 4%, the HCE limit using the first test would be 5% (4% x 1.25 = 5%) or 6% (4% + 2% = 6%) using the second test.

This restriction is one of the ways the government tries to ensure that employers create plans that encourage participation across the full range of employees, not just by those that are highly paid. If a plan doesn’t pass the test, it risks being disqualified, so employers take the rule seriously. It’s also one of the reasons employers require a minimum contribution of employees who wish to participate.