What Is Retro Pay in Payroll and How Does It Work?
Uncover how retro pay functions in payroll, correcting past underpayments to ensure employees receive accurate, owed compensation.
Retro pay, short for retroactive pay, is a payroll adjustment that corrects an underpayment to an employee for work already performed. Its purpose is to rectify past payroll errors or to account for changes in compensation that were not applied promptly.
What is Retro Pay and Why it Happens
Retro pay is compensation an employer owes an employee when they were underpaid or not paid correctly for work completed in a prior pay period. It is not a bonus or an additional payment, but rather a correction to fulfill an outstanding wage obligation.
Common scenarios leading to retro pay include delayed implementation of salary increases or promotions. For instance, if a raise is effective January 1st but not processed until March, retro pay covers the difference for January and February. Errors in calculating regular hours or overtime are also frequent causes, ensuring employees receive the correct premium rates for their work. Other instances involve missed commission or bonus payments that were due, or the application of incorrect pay rates. Sometimes, late submission of timesheets or expense reports can also necessitate a retro pay adjustment to account for all hours worked or reimbursements due.
How Retro Pay is Calculated and Paid
The calculation of retro pay involves determining the precise difference between the amount an employee was paid and the amount they should have been paid for a specific period. This process requires reviewing past pay periods to identify the duration of the underpayment and applying the correct rate or amount to those periods. For hourly employees, the difference in hourly rates is multiplied by the number of underpaid hours. For salaried employees, the difference in pay per period is multiplied by the number of affected pay periods.
After the retro pay amount is calculated, employers typically disburse it through common payroll methods. One common approach is to include the retro pay as a distinct line item on a subsequent regular paycheck, clearly indicating the adjustment. Alternatively, employers may issue the retro pay as a separate, off-cycle payment, such as a special check or direct deposit. The method of disbursement often depends on company policy, the payroll system’s capabilities, and the amount of the retro payment.
Tax Implications of Retro Pay
Retro pay is generally considered taxable income, similar to regular wages, and is subject to all applicable payroll taxes. This includes federal income tax withholding, which employers must deduct. For federal income tax purposes, retro pay is often treated as supplemental wages, which can be subject to a flat 22% withholding rate if paid separately, or taxed based on the employee’s regular withholding if combined with regular wages.
In addition to federal income tax, retro pay is subject to Social Security and Medicare taxes, collectively known as FICA taxes. These taxes are withheld at standard rates, with both the employee and employer contributing their respective shares. State and local income taxes are also applicable if the employee resides in or works in a jurisdiction that imposes such taxes. While a large lump sum of retro pay might affect the withholding for that specific pay period, the overall annual tax liability is ultimately based on the employee’s total annual income from all sources.