What Are Retroactive Earnings and How Do They Work?
Unpack the complexities of retroactive earnings, from their origin and calculation to their tax and reporting requirements.
Retroactive earnings represent a type of compensation that corrects a past payment shortfall. These adjustments ensure employees receive the full amount they were entitled to for work already performed. Various situations can lead to retroactive pay, ranging from administrative oversights to negotiated salary adjustments. Understanding how these earnings are calculated, taxed, and reported is important for both employees and employers.
Defining Retroactive Earnings
Retroactive earnings, commonly referred to as retro pay, are payments made to an employee to address an underpayment in a previous pay period. It is distinct from “back pay,” which typically refers to wages owed for periods where an employee received no compensation at all, often due to legal disputes or unpaid wages for time worked. Retroactive pay corrects errors or delays in compensation, ensuring employees receive their rightful earnings. The core concept centers on rectifying a compensation discrepancy that occurred in a prior period but is settled in a current or future pay cycle. Retroactive pay can arise from various scenarios, such as when a new pay rate is effective on a certain date but not implemented in the payroll system until later.
Situations Leading to Retroactive Pay
Retroactive pay arises from several circumstances:
- A delayed pay raise, where an approved salary increase is effective from a certain date but the payroll system is not updated immediately. This necessitates a payment to cover the difference between the old and new rates for the period of delay.
- Payroll errors also frequently lead to retroactive adjustments. These can include incorrect hourly rates, miscalculations of hours worked, or inaccuracies in applying shift differentials or commissions. For example, if an employee’s overtime hours were paid at a regular rate instead of the legally required higher rate, retroactive pay would be due to cover the difference.
- Changes in employment status, such as promotions or reclassifications that carry a higher pay rate, can also trigger retroactive payments if the new rate is not implemented from its effective date.
- Collective bargaining agreements or union negotiations might result in wage adjustments that are applied retroactively to a specified past date.
Determining the Retroactive Amount
Calculating retroactive pay involves a precise comparison of the amount an employee was paid against the amount they should have received for a past period. The fundamental method is to subtract the actual pay from the correct pay for the affected timeframe. This difference represents the gross retroactive amount owed to the employee.
For hourly employees, the calculation typically involves determining the difference between the old hourly rate and the new, correct hourly rate. This per-hour difference is then multiplied by the total number of hours worked during the period for which the underpayment occurred. For instance, if an employee should have been paid $20 per hour but was paid $18, the $2 difference per hour is multiplied by all hours worked during the retroactive period.
For salaried employees, the calculation focuses on the difference between the old salary and the new, correct salary for the specific pay periods affected. This might involve prorating the annual salary difference over the number of pay periods in question. For example, if a salary was increased by $2,000 annually, and two bi-weekly pay periods were affected before the change was implemented, the retroactive amount would be a proportional share of that annual increase for those two periods.
It is important to include all types of compensation in the calculation, such as regular wages, overtime, bonuses, or commissions, to ensure the full underpayment is corrected. The period for which retroactive pay can be claimed might be limited by state and federal wage laws, often ranging from two to six years depending on the specific claim.
Understanding Tax and Payroll Reporting
Retroactive earnings are generally treated as regular wages for tax purposes, meaning they are subject to federal income tax withholding, Social Security, and Medicare taxes. These payments are often considered supplemental wages by the Internal Revenue Service (IRS). Employers must withhold federal income tax from supplemental wages. For amounts up to $1 million in a calendar year, employers can use either an aggregate method, combining supplemental wages with regular wages for withholding purposes, or a flat 22% rate. If an employee receives more than $1 million in supplemental wages during a calendar year, the amount exceeding $1 million is subject to a mandatory federal income tax withholding rate of 37%.
Social Security tax is withheld at a rate of 6.2% on earnings up to the annual Social Security wage base limit, and Medicare tax is withheld at 1.45% on all earnings, with an additional Medicare tax of 0.9% on wages exceeding certain thresholds. These rates apply to retroactive payments just as they do to regular earnings.
On an employee’s pay stub, retroactive pay is typically itemized separately to distinguish it from regular earnings for the current pay period. This helps in understanding the components of the total pay. For year-end tax reporting, retroactive earnings are included in Box 1 (Wages, Tips, Other Compensation) of Form W-2 for the year in which the payment is actually made, regardless of when the wages were earned.