What Is Retroactive Pay and How Is It Calculated?
Gain a complete understanding of retroactive pay, from its definition to how it's determined and its financial implications for you.
Retroactive pay represents compensation an employee receives for work already performed, but which was initially underpaid. It addresses a shortfall where an employee received less than the amount they should have been paid. Retroactive pay is distinct from “back pay,” which refers to compensation owed for work where no payment was made at all.
Understanding Retroactive Pay
Retroactive pay arises when a compensation change or correction was not applied in a timely manner to an employee’s wages. A common circumstance involves delayed pay raises, where an approved salary increase is effective from a certain date but the payroll system is updated later. In such cases, retroactive pay covers the difference between the old and new pay rates for the period before the raise was fully implemented.
Payroll errors frequently necessitate retroactive pay adjustments. These can include incorrect hourly rates being entered into the payroll system or overlooked hours, leading to an underpayment. Miscalculations of overtime wages are another source of retroactive pay. Federal law mandates that employees working over 40 hours in a workweek receive overtime at 1.5 times their regular rate, and failing to apply this correctly results in owed retroactive pay.
Changes in minimum wage laws can also trigger retroactive pay if an employer fails to adjust wages promptly to meet the new legal minimum. Wage disputes or settlements, often resulting from legal proceedings or contractual agreements, may also lead to retroactive payments to cover past underpayments. Other instances include inaccurate compensation for bonuses, commissions, or shift differentials that were not properly accounted for.
Calculating Retroactive Pay
Calculating retroactive pay involves determining the difference between the amount an employee was actually paid and the amount they should have been paid for a specific period. For hourly employees, this calculation involves subtracting the old or incorrect hourly rate from the new, correct rate to find the per-hour difference. This difference is then multiplied by the number of hours worked during the affected period.
For salaried employees, the calculation involves determining the difference in pay per pay period. This is found by subtracting the old gross pay per period from the new gross pay per period. That per-period difference is then multiplied by the number of pay periods that the underpayment occurred. Calculations use an employee’s gross pay before any taxes or deductions.
The process requires gathering relevant data, such as the effective date of any pay change, the employee’s previous and current pay rates, and records of hours worked or pay periods affected. Once the total retroactive amount is determined, it is typically added to the employee’s next regular paycheck, often listed as a separate item.
Taxation of Retroactive Pay
Retroactive pay is considered taxable income and is subject to various payroll taxes. Like regular wages, it is subject to federal income tax withholding, state income tax withholding (where applicable), and Federal Insurance Contributions Act (FICA) taxes, which include Social Security and Medicare taxes.
The Internal Revenue Service (IRS) treats retroactive pay as “supplemental wages.” For federal income tax withholding, employers have options when processing supplemental wages. They can either withhold a flat 22% tax rate if the amount is paid separately from regular wages, or they can combine the retroactive pay with the employee’s regular wages for the pay period and withhold taxes based on the employee’s W-4 and the standard income tax withholding tables. FICA taxes, however, are always withheld at their normal rates, regardless of the method used for income tax.
Retroactive pay is taxed in the period it is paid, not the period it was earned. This can have implications, particularly if a large lump-sum retroactive payment is received. A substantial payment could increase an individual’s taxable income for the year it is received, potentially pushing them into a higher income tax bracket for that specific pay period or tax year. Any over-withholding of taxes due to a large lump sum is typically reconciled when the individual files their annual income tax return.