Sometimes, payroll mistakes happen. If you pay an employee less money than you should have during a pay period, you owe them retro pay. What is retro pay?
What is retro pay?
Retro pay, or retroactive pay, is the compensation you owe an employee for work performed during a previous pay period. The difference between what an employee should have received and what you paid them is the amount of a retro payment. You must provide a retroactive payment if you miscalculate an employee’s compensation or forget to account for a raise.
Retro pay differs from back pay. Back pay is when you owe employees wages you didn’t pay, whereas retro pay is when you paid an employee less than what you should have.
When do you need to make a retro adjustment?
Take a look at some of the reasons you may need to make a retro adjustment:
Pay raises: When you offer an employee a pay raise, you might run payroll using their old pay rate.
Miscalculated wages: No matter how many times you run payroll, mistakes happen. Miscalculated wages happen when you enter the incorrect pay rate or number of hours worked.
Miscalculated overtime earnings: When an employee works over 40 hours in a workweek, you must pay them the overtime rate for the additional hours. An employee’s overtime pay is miscalculated when you forget to multiply their hourly rate by 1.5.
Shift differentials: You may forget to pay an employee a shift differential if they work some or all of their hours at different pay rates. Shift differentials are when you pay an employee a higher pay rate to work outside normal business hours, such as an evening or night shift.
Multiple pay rates for different positions: If an employee works two or more positions in your business and earns different pay rates, you may use the wrong rate when you run payroll.
Commissions: Unless you use the draw against commission system, you might not pay commissions to an employee until the customer pays.
Bonuses: When an employee earns a bonus during a pay period, you may not pay it to them until a later period.
How does retro pay work when calculating wages?
To calculate retro pay, subtract what you paid the employee from what you should have paid the employee. Use their gross pay when calculating, then withhold taxes after.
Take a look at the following examples to answer How does retroactive pay work?
How to calculate retro pay for hourly employees owed overtime wages
Let’s say you pay an employee $10 per hour using a weekly pay frequency. Your employee worked 45 hours during one week. Instead of paying them the overtime rate for the five hours of overtime, you paid them their regular rate of $10 per hour.
First, calculate how much you paid the employee in gross wages for the week. The employee’s gross pay was $450 ($10 X 45).
Next, calculate how much you should have paid the employee in overtime wages. To find their overtime rate, multiply their hourly pay rate by 1.5, then multiply by the number of overtime hours worked. The employee should have received overtime wages of $75 ($10 X 1.5 X 5).
Now, calculate how much you should have paid the employee during the week by adding their overtime and regular wages together. The employee’s regular wages are $400 ($10 X 40). The employee’s gross wages should have been $475 ($400 + $75).
Lastly, subtract what you paid the employee ($450) from what they should have received ($475) to determine their retro pay. You owe the employee $25 ($475 – $450) in retroactive wages.
Don’t forget that the employee’s retro pay of $25 is subject to employment taxes.
How to calculate retroactive pay raise for salaried employees
Let’s say an employee earns $35,000 per year. You give them a $7,000 (per year) increase to bring their annual salary up to $42,000. The following pay period, you forget to run payroll using their new pay rate. You pay the employee semimonthly. There are 24 periods under a semimonthly pay frequency.
First, you need to know the employee’s gross pay per period prior to their raise. The employee earned gross wages of $1458.33 per pay period prior to their raise ($35,000 / 24).
Next, determine how much you should pay the employee with the raise. Divide their new annual salary of $42,000 by 24. The employee’s semimonthly pay should now be $1,750.00.
Lastly, subtract how much you paid the employee in gross wages from how much you should have paid them ($1,750.00 – $1,458.33). You owe the employee $291.67 in retro pay.
Now, let’s say you forgot to include the employee’s raise in 2 payrolls. To provide the correct retro pay, you must multiply the difference of $291.67 by 2. You owe the employee $583.34 in retro pay.
Remember, retro pay is subject to employment taxes. The amount you owe the employee in gross wages is not the amount they will take home.
Paying retro pay
Generally, you can use one of two methods to pay retro earnings. You might add retro payments to an employee’s regular wages, or you may provide retroactive pay as a standalone payment.
Regardless of your payment method, ensure the employee understands what the retro wages are for. Be clear that these are not extra wages, but wages the employee previously earned. Include retro on pay stub so you and your employee have the adjustment in your records.
Keep in mind that how you provide retro payments influences tax withholding.
Retroactive pay and tax withholding
You are required to withhold and remit payroll and income taxes on retro pay. And, you must pay the employer portion of payroll taxes.
Before giving employees their retroactive payment, withhold:
- Social Security and Medicare taxes (FICA)
- Federal income tax
- State income tax (if applicable)
- Local income tax (if applicable)
Retro pay is a type of supplemental pay. Supplemental wages are additional compensation you give employees. To withhold federal income tax from supplemental pay, you must either use the percentage or aggregate method.
You can use the percentage method if you give retroactive pay on its own. Under the percentage method, withhold a flat 22% for federal income taxes.
Use the aggregate method if you add the employee’s retro pay to their regular wages for the following period. Using the aggregate method, withhold taxes on the sum using the income tax withholding tables in IRS Publication 15.
Withhold FICA tax as normal. Consult your state for information on withholding state and local income taxes on retroactive pay.
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This article has been updated from its original publication date of 11/26/2014.
This is not intended as legal advice; for more information, please click here.