Retro pay isn’t some vintage method people used to pay themselves back in the day. Short for retroactive pay, these payments reconcile the difference between the rate an employee should have been paid and the rate an employee was paid.
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For example, let’s say your employee, Linh, works as both a customer service representative and an engineer and is paid different rates for her two roles. She makes $20 per hour as a customer service representative and $25 per hour as an engineer.
Maybe you accidentally paid for 10 hours of engineering work using the lower customer service rate, and Linh’s latest paycheck said she earned $200. But she should have made $250, and you’ll have to pay her the difference.
That $50 is retroactive pay—pay she would have earned in a previous pay period if her paycheck had been calculated correctly.
Wait, what’s the difference then between retro pay and back pay?
Back wages make up the difference between what your employee was paid and what they should have been paid. It includes things like unpaid bonuses, missed overtime pay, or failing to pay an employee entirely for the time they worked.
Huh? Yeah, these two terms can be very confusing.
An easy way to keep them apart:
- Retroactive pay is used to correct the rate of pay or salary for a historical period.
- Back pay is used to correct missed bonuses, missed regular hours worked, or missed overtime hours worked.
If you gave your employee a raise but forgot to input it into the system, you would owe them retroactive pay. If you forgot to pay them entirely for a day of work, you would owe back pay.
Gotcha. When will I need to pay my employees retroactively?
Retroactive pay isn’t too common—and many of the causes are simply human error. Keep an eye out for these situations:
- Raises: If a raise was given, but the new salaries weren’t entered into the system before you ran payroll, you can apply your employees’ raises retroactively.
- Payroll errors: In a situation like Linh’s, above, or any other payroll mistakes, you will have to give retroactive pay to correct the mistake.
- Overtime miscalculations: If you applied the wrong overtime rate, retroactive pay can fix the difference.
- Commission: If you failed to pay an employee’s commission as established in their employment agreement, you might owe them retro pay.
How do I calculate retro pay?
You’ll need the following information to calculate how much you owe your mispaid employee:
- Their correct gross pay per period,
- How much money your company actually paid the employee, and
- The number of pay periods in which your employee was mispaid.
Let’s take our employee, Linh, from above. What if you paid her the wrong salary for two two-week pay periods?
If she worked full-time as an engineer during those pay periods, she would be owed $2,000 each paycheck: 80 hours at $25 per hour. But if you accidentally paid her with her customer service rate, she would have instead received $1,600 per paycheck. That’s a $400 difference each pay period—so Linh deserves $800 in retro pay.
How do I pay my employees’ retroactive pay?
Once you realize the error, there are three ways to pay your employees the amount they’re owed.
- Do a separate payroll run. Make sure to label the pay RETRO on the paystub so your employee isn’t confused.
- Include the retroactive pay on your employee’s next check and identify it. Again, label the retroactive pay appropriately.
- Combine retroactive pay with regular wages on your employee’s next paycheck. For this option, no need to use the RETRO label. (Be sure to check with your payroll provider or accountant to see if this option is applicable in your state. Many states require you to include the exact dates of the period for which the employee is paid.)
Just like with normal pay, you need to withhold Social Security, Medicare, and applicable state and local taxes from retroactive pay.
Income tax is where it’s a little different for retroactive pay. The IRS considers retroactive wages “supplemental wages,” or money paid to an employee outside their normal salary.
How you take out income tax out of retro pay depends on which of the three payroll options you choose.
If you run a separate payroll or designate the retroactive pay separately on your employee’s paycheck, you have two options:
- Withhold a flat 22% from the sum of the retroactive pay.
- Add the retro pay amount to the normal wages from either the current payroll or the most recent payroll. Then use the combined sum to determine the appropriate federal income tax withholding, and subtract the amount being withheld or already withheld for the normal wages. Withhold what’s leftover from the retroactive wages.
If you add the sum to the next paycheck but do not specify how much is retroactive pay and how much is regular wages, withhold federal income taxes from the combined amount just as you would for a normal payroll.
Anything else I need to know?
Some states have their own laws about retroactive pay. For example:
- Texas prevents retroactive pay to employees of state agencies or institutes of higher education—unless the employees are contractually or legally obligated to higher wages that they were not paid.
- In California, employees can sue their employer if their pay statements do not include the exact dates of the period for which the employee is paid. So if you’re paying retroactive or back pay, make sure that the payroll periods are clearly noted on the pay statement. California also doesn’t allow retroactive pay to any public officer, employee, or contractor after they’ve rendered service or completed their contract.
Check the laws in your state to be sure you understand any specific local legislation.
Phew! That was a lot. If you’d rather avoid figuring out all the complexities of retro pay on your own, you can get a full-service payroll system to help.