What Are Retroactive Earnings and How Are They Taxed?
Demystify retroactive earnings. Grasp their core meaning, how they are calculated, and the vital tax considerations involved.
Retroactive earnings represent a payment for work or compensation that should have been paid in an earlier period. These payments also correct an underpayment from a past pay period, ensuring employees receive the full amount they were entitled to.
Understanding Retroactive Earnings
Retroactive earnings, often called retro pay, are adjustments made to an employee’s compensation to correct a shortfall in a previous pay period. This compensation is not for new work but rather a delayed payment of existing entitlements that were underpaid. It bridges the gap between what an employee was actually paid and what they should have been paid.
Retroactive earnings arise when a change in compensation, such as a pay raise or benefit adjustment, is applied after its effective date. They can also result from errors in payroll processing, miscalculations of hours worked, or incorrect application of pay rates. The goal is to ensure accurate compensation for work already performed.
Calculating Retroactive Earnings
The calculation of retroactive earnings involves determining the difference between the amount an employee was paid and the amount they should have been paid. This process requires identifying the specific pay periods affected by the discrepancy. Employers must pinpoint the original pay rate and compare it to the corrected pay rate.
Once the per-period difference is established, it is multiplied by the hours worked or the duration of the affected period. For instance, if an hourly employee was underpaid by $1 per hour for 160 hours, the retroactive pay would be $160. For salaried employees, the calculation involves prorating the salary adjustment over the affected timeframe.
Tax Implications of Retroactive Earnings
Retroactive earnings are considered taxable income in the period they are actually paid to the employee, not when they were originally earned. These payments are subject to federal income tax withholding, Social Security (FICA) tax, and Medicare tax, similar to regular wages.
The Internal Revenue Service (IRS) often treats retroactive pay as supplemental wages for federal income tax purposes. For supplemental wages, employers may either withhold a flat 22% for federal income taxes or combine the retroactive payment with regular wages. While Social Security and Medicare taxes are withheld at their standard rates, the lump sum nature of some retroactive payments can potentially influence an individual’s overall tax bracket for the year received.
Common Situations Leading to Retroactive Earnings
Delayed pay raises are a common scenario, where an approved salary increase or promotion is not immediately reflected in payroll. This requires employers to pay the difference from the effective date of the raise.
Payroll errors are another frequent cause, including incorrect hourly rates, miscalculated overtime, or missed hours. Delayed bonuses or commissions, or changes in pay grade or job classification applied retrospectively, can also lead to retroactive payments. Back pay resulting from legal settlements, arbitration awards, or adjustments due to new union contracts are other examples.