Taxation and Regulatory Compliance

What Are Retroactive Earnings and How Are They Taxed?

Learn about retroactive earnings, a unique form of compensation for past work. Understand how these payments are processed and their tax implications.

Retroactive earnings are compensation an employee receives for work performed in a past period when the original payment was less than what should have been paid. This adjustment often arises when a pay rate or amount is later corrected or increased, applying to a period already worked.

Understanding Retroactive Earnings

Retroactive earnings represent payments for work that has already been completed but was initially compensated at an incorrect or lower rate.

Common scenarios for retroactive payments include delayed pay raises, where an approved increase is not immediately reflected in payroll. Payroll errors or underpayments, such as miscalculated regular hours or overtime wages, also lead to retroactive adjustments. Additionally, retroactive earnings can stem from the backdated application of new pay scales or union contract negotiations, ensuring employees receive correct compensation from an agreed-upon effective date.

Calculating Retroactive Earnings

Calculating retroactive earnings involves determining the difference between the amount an employee was paid and the amount they should have been paid for a specific period. This calculation requires accurate records of previous pay rates, new pay rates, and the affected work hours or pay periods. The difference in pay is then multiplied by the number of hours worked or pay periods impacted by the change.

For example, if an employee received a raise from $15 to $17 per hour, effective two weeks prior to its implementation, and worked 80 hours during those two weeks, the retroactive pay would be $2 per hour ($17 – $15) multiplied by 80 hours, totaling $160. For a salaried employee, the calculation involves finding the difference between the old and new salaries for the affected period, prorated over the relevant pay cycles.

Tax Implications of Retroactive Earnings

Retroactive earnings are subject to the same tax withholdings as regular wages. These include federal income tax, state income tax, and Federal Insurance Contributions Act (FICA) taxes. Employers are responsible for correctly withholding and reporting these taxes.

For federal income tax purposes, the Internal Revenue Service (IRS) treats retroactive pay as supplemental wages. Supplemental wages are payments made in addition to an employee’s regular pay. Employers have two methods for federal income tax withholding on supplemental wages: applying a flat 22% rate, or combining the supplemental wages with regular wages and using the employee’s Form W-4 to calculate withholding.

FICA taxes, including Social Security and Medicare taxes, apply to retroactive earnings just as they do to regular wages. The Social Security tax rate is 6.2% for both the employee and employer, applied up to an annual wage base. The Medicare tax rate is 1.45% for both the employee and employer, with no wage limit. An additional 0.9% Medicare tax applies to employee wages exceeding $200,000 for single filers, $250,000 for joint filers, or $125,000 for married filing separately. Retroactive earnings are reported on an employee’s Form W-2 in the year they are paid, usually combined with regular wages.

Previous

What Office Supplies Are Tax Deductible?

Back to Taxation and Regulatory Compliance
Next

How to Write an Appeal Letter for Insurance