What Is Retro Pay? How It’s Calculated and Taxed

Retro pay represents compensation added to an employee’s earnings to correct an underpayment from a prior pay period. It acts as an adjustment to rectify past payment errors or omissions, bringing an employee’s total compensation for a given period to its accurate level.

Reasons for Retro Pay

Several common scenarios can lead to an employee receiving retro pay. One frequent cause is a delayed implementation of a pay raise or promotion. If an employee’s new, higher rate of pay is approved to start on a specific date but is not reflected in their paycheck until a later period, retro pay covers the difference for the time they were underpaid.

Payroll processing errors are another significant reason for retro pay. These errors can include mistakes such as an incorrect hourly rate being applied, a miscalculation of overtime hours, or entirely missed hours that were worked but not compensated. When such discrepancies are identified, employers are obligated to correct the shortfall.

Retro pay may also become necessary due to changes in compensation policies that are applied retroactively. The goal in all these situations is to bridge the gap between what was paid and what should have been paid, ensuring fair compensation.

Calculating Retro Pay

Calculating retro pay involves determining the precise difference between the amount an employee was paid and the amount they should have received for a specific period. All relevant data, such as past pay stubs, timesheets, and the effective date of any pay changes, are necessary for this calculation.

For example, if an employee’s hourly rate increased by $2 per hour, and this raise was supposed to be effective for 80 hours worked in a previous pay period but was not applied, the retro pay would be $160 ($2 per hour x 80 hours). Similarly, for a salaried employee, the difference between the old and new per-pay-period salary is multiplied by the number of affected pay periods.

The calculation focuses on the gross amount of wages owed before any deductions. After determining this gross figure, the employer then applies the necessary withholdings and deductions, similar to regular wages, to arrive at the net retro pay amount.

Retro Pay and Taxes

Retro pay is considered taxable income, just like an employee’s regular wages. This means it is subject to federal income tax withholding, Social Security taxes (FICA), Medicare taxes, and any applicable state or local income tax withholding.

For federal income tax purposes, retro pay is often classified as “supplemental wages.” The Internal Revenue Service (IRS) provides employers with two primary methods for withholding federal income tax from supplemental wages. If the retro pay is identified separately from regular wages, employers can withhold a flat 22% for amounts under $1 million.

Alternatively, employers can use the aggregate method, where the retro pay is combined with the employee’s regular wages for the current or preceding pay period. Under this method, federal income tax is withheld from the combined amount as if it were a single payment, using the employee’s Form W-4 information. Social Security tax is withheld at a rate of 6.2% for both the employer and employee, up to an annual wage base limit, while Medicare tax is 1.45% for both parties with no wage base limit. The entire retro pay amount, including all applicable taxes, will be included in the employee’s total wages on their W-2 form for the year in which it was paid.