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

Compensation for work is a key aspect of employment. Employees expect accurate and timely pay. While regular paychecks are standard, adjustments are sometimes necessary for past work.

Understanding Retro Payments

A retro payment, or retroactive pay, refers to compensation issued to an employee for work performed in a previous period that was not correctly paid. This payment corrects a shortfall in an earlier compensation cycle, ensuring the worker receives the full amount earned. It differs from “back pay,” which refers to wages entirely missed or unpaid.

Common scenarios necessitating retro payments include delayed pay raises or promotions where the new, higher rate is applied from an earlier effective date. Payroll errors, such as incorrect hourly rates, miscalculated hours, or missed allowances, often require retroactive adjustment. Adjustments for overtime miscalculations or overlooked commission payments can also result in retro payments.

How Retro Payments are Calculated

Calculating a retro payment involves determining the exact difference between the amount an employee was paid and the amount they should have received for a specific past period. The first step is to identify the precise timeframe during which the underpayment occurred. This period typically extends from the effective date of a pay change or the date of a payroll error until the correction is implemented.

For hourly employees, the difference between the old and new hourly rates is multiplied by the total hours worked during the retroactive period. For salaried employees, the difference in pay per pay period (e.g., bi-weekly or semi-monthly) is determined and then multiplied by the number of affected pay periods. Employers often use payroll systems to calculate these amounts accurately, though manual calculations are also performed to sum the differences for the entire retroactive period.

Taxation of Retro Payments

Retro payments are considered taxable income, similar to regular wages. They are subject to federal income tax withholding, as well as Social Security and Medicare taxes, collectively known as FICA taxes. The employee’s portion of FICA taxes is 6.2% for Social Security (up to an annual wage base limit) and 1.45% for Medicare, with an additional 0.9% Medicare tax on wages exceeding $200,000 for single filers.

A key aspect of their taxation is that retro payments are typically taxed in the period they are paid (received by the employee), not the period they were earned. This means the payment will be included in the employee’s gross income for the tax year it is disbursed. State and local income taxes may also apply to retro payments, depending on the jurisdiction where the employee resides and works.