Who counts as an employee for your 401(k) plan—and why it matters

^{[Updated article; original publish date October 21, 2021]}

How are employees classified?   

When reviewing your workforce, start with a few basic questions:

• Was the worker hired directly by your company or through a staffing or leasing company?
• Do you control how the person does their work?
• Is the worker treated as a W-2 employee or paid as a contractor?
• Are there related companies that may need to be treated as one employer for plan purposes?

The answers can help you classify each worker and determine whether they must be considered under your plan. Here’s a brief look at four different categories and how they may affect your plan administration.    

1 Common law employees

A common law employee is someone who works for your company and whose work your company has the right to direct and control. To decide whether a worker is an employee, you need to look at the full working relationship. A job title or tax form alone isn’t enough to decide.

Impact on 401(k) administration

Common law employees are generally the starting point for determining who can participate in your plan and who must be included in required plan testing. The plan’s eligibility rules and any permitted exclusions determine how each employee is treated.

2 Independent contractors

If you hire contract workers, you might think they aren’t your employees, but the IRS may see it differently. What matters is how the working relationship actually operates—especially how much control your business has over the person’s work. The IRS considers a variety of factors when determining if a worker is an employee or an independent contractor, with a focus on behavioral control, financial control, and the overall relationship between the parties. For example, the IRS may consider whether the individual:

• Uses their own supplies or equipment to perform the requested services
• Provides similar services for more than one company at a time
• Makes their services available to the general public
• Sets their own hours and location
• Realizes a profit or a loss

Keep in mind a worker doesn’t have to meet every factor to qualify as an employee or independent contractor, and no single factor controls the result.

Impact on 401(k) administration

Properly identifying independent contractors is vital. If someone treated as an independent contractor is later found to be a common law employee, they may have been wrongly excluded from your 401(k) plan. Fixing this mistake can be costly.

3 Leased employees

A leased employee is someone employed through a staffing or leasing company who works at your business on a substantially full-time basis and under your primary direction or control for at least a year.

Impact on 401(k) administration

While leased employees are paid by another company and may be excluded from plan participation, they may still need to be considered for certain qualification, coverage, nondiscrimination, and top-heavy testing requirements. A narrow exception may apply when the leasing company provides a qualifying retirement plan and the leased employees make up no more than 20% of your nonhighly compensated workforce.

4 Nonresident aliens

A nonresident alien is generally a person who isn’t a U.S. citizen and doesn't count as a U.S. tax resident. For this rule, don't confuse it with someone who isn’t a U.S. citizen but earns money from U.S. sources. That’s not always the same thing.

You may be able to exclude nonresident aliens who don’t receive any U.S. source earned income from your company. In certain cases, they may also be excluded if their U.S. source earned income is exempt from U.S. income tax under an applicable tax treaty.

Impact on 401(k) administration

Nonresident aliens may be excluded from coverage testing if the statutory exclusion applies. If the exception doesn’t apply, those workers who earn income from U.S. sources may need to be included in your plan under your eligibility rules and required testing. Review where these employees perform their work and how their income is reported and taxed before excluding them to be sure they’re treated correctly.

Who are key and highly compensated employees? 

Once you know which employees can join your plan, the next step is to identify key and highly compensated employees (HCEs).

Key employees

Key employees matter mainly for determining whether your plan is top-heavy. If more than 60% of your plan’s assets belong to key employees, you may need to provide minimum contributions for non-key employees and follow faster vesting rules.

For 2026, a key employee is an employee who, at any time during the applicable testing period, is:

• An officer with annual compensation exceeding $235,000 (indexed for inflation), or
• A 5% owner of your business, or
• A 1% owner of your business with annual compensation of more than $150,000 (not indexed)

The number of officers who may be treated as key employees is capped at the lesser of:

• 50 employees or
• The greater of 3 employees or 10% of all employees

If an employer has more than 500 employees, the maximum number of officers counted as key employees is 50. Whether someone is an officer depends on their authority, not just their title.

Highly compensated employees

Identifying HCEs is important for nondiscrimination testing. For 2026, an HCE is an employee who:

• Was a 5% owner at any time during the determination or look-back year; or
• Received more than $160,000 (indexed for inflation) in compensation during the prior-year look-back period (2025 for determining 2026 status) and, if the employer made the top-paid group election, was in the top-paid group for that year

The top-paid group election can reduce the number of employees treated as HCEs for testing purposes. This may make it easier for your plan to satisfy nondiscrimination testing requirements, as only the highest-paid 20% of eligible employees (rather than all employees above the HCE compensation threshold) are treated as HCEs. However, the election must be applied consistently across all related employers in a controlled group.

Impact on 401(k) administration

The key employee definition is used for top-heavy testing, while the HCE definition is used for coverage, ADP, ACP, and other nondiscrimination testing. If employees aren’t properly identified, testing results may be inaccurate and create compliance issues for your plan.

Who’s a higher-paid employee? 

Just when you thought there were already enough employee classifications to keep track of, SECURE 2.0 introduced another one: the higher-paid employee. This classification applies only to the Roth catch-up contribution rules and is different from the key employee and HCE definitions used for retirement plan testing. The determination is based on prior-year FICA wages, not the compensation definition used for plan contributions and testing.

For 2026, a higher-paid employee is an employee whose 2025 Social Security (FICA) wages exceeded $150,000 (indexed for inflation).

In most cases, identifying those wages is straightforward. However, when employees work for related companies, participate in a multiple-employer plan, or are employed by an adopting employer rather than the plan sponsor, additional review may be needed to determine which wages count toward the threshold.

The higher-paid and HCE classifications may sound similar, but they're used for different purposes. Because these rules use different compensation and thresholds, a person may be classified one way under one rule and differently under the other. An employee can be an HCE but not a higher-paid employee, or a higher-paid employee but not an HCE.

Impact on 401(k) administration

Misclassifying a higher-paid employee can result in catch-up contributions being made on the wrong tax basis (pretax vs. Roth). Establishing procedures to identify affected employees each year can help you avoid this issue.

Know who counts as an employee

How you categorize your employees affects more than payroll and tax reporting. It affects who gets into your 401(k) plan, who must be counted in plan testing, who's subject to special catch-up rules, and whether corrections may be needed later. They can also change as your workforce and pay levels change.

That’s why it’s important to review your employee classifications at least annually—and whenever you hire through a staffing company, add a related business, or change how a worker is paid. Managing all the different categories can be challenging. But you don’t have to do it alone. Your plan’s third-party administrator or ERISA specialist can help keep your plan on track.