What Is a Retro Pay and How Does It Work?

Retroactive pay, often called retro pay, represents a compensation adjustment for past periods when an employee received less than the amount they were due. This payment ensures individuals are fully compensated for their work, correcting payroll discrepancies and maintaining accurate financial records for both employers and employees.

Understanding Retro Pay

Several common scenarios lead to the need for retro pay. One frequent reason is a delayed pay raise or promotion, where an increase was approved to be effective on a certain date, but the payroll system was not updated in time. Payroll errors, such as miscalculating hours worked, entering an incorrect pay rate, or omitting a bonus or commission, also frequently necessitate retro payments. Additionally, miscalculations of overtime wages, where an employee was paid at their regular rate instead of the required time-and-a-half for hours exceeding 40 in a workweek, are a common cause for retro pay. Changes in pay rates due to new contracts or minimum wage increases that apply to past work periods can also result in an employer owing retro pay.

Calculating and Taxing Retro Pay

Calculating retro pay involves determining the difference between what an employee was actually paid and what they should have been paid for a specific period. For hourly employees, this might involve subtracting the old hourly rate from the new hourly rate and multiplying that difference by the number of underpaid hours. For salaried employees, the calculation involves finding the difference between the old and new pay per pay period and multiplying it by the number of affected pay periods.

Retro pay is considered wages and is subject to the same tax withholdings as regular income. This includes federal income tax, state income tax, Social Security tax, and Medicare tax (FICA taxes). The IRS generally treats retro pay as supplemental wages for federal income tax purposes. Employers typically have two methods for withholding federal income tax from supplemental wages: a flat 22% rate, or combining the retro payment with the employee’s regular wages and withholding based on the total amount. While the tax rate on retro pay is not inherently higher, receiving a large lump sum can sometimes result in more tax being withheld from the paycheck.

Receiving Retro Pay

When an employee receives retro pay, it typically appears on their pay stub. This payment might be listed as a separate line item to clearly distinguish it from regular earnings, or it could be integrated into the regular earnings amount. The pay period dates associated with the retro payment on the stub should clearly indicate the specific past period the adjustment covers. This transparency helps employees understand the correction being made.

Upon receiving retro pay, an employee should verify several details to ensure accuracy. It is advisable to confirm that the correct pay rates were used for the calculation, especially if the retro pay stems from a raise or a change in pay structure. The employee should also check the specific dates covered by the retro payment to ensure all underpaid periods have been addressed. Finally, it is important to review that all applicable deductions, such as federal, state, and local taxes, as well as Social Security and Medicare contributions, have been correctly applied to the retro amount.