What Is Retro Pay? How Do I Calculate It?

What Is Retro Pay? How Do I Calculate It?

Deskera Content Team
Deskera Content Team
Table of Contents
Table of Contents

Payroll mistakes do occur from time to time. You owe an employee retro pay if you pay them less than you should have during a pay cycle. But, what exactly is retro pay?

Understanding Retro Pay

Retro pay, also known as retroactive pay, is money owed to an employee for work done during a former pay period. The sum of a retro payment is the difference between what an employee should have gotten and what you paid them. You must make a retroactive payment if you miscalculate an employee's wages or omit to account for an increase.

There’s another concept that is different from retro pay but still is used in its place. It is known as back pay which is not at all the same as retro pay. When you owe an employees' salary that you didn't pay at all, it's called back pay, whereas retro pay is when you paid an employee less than you should have. We’ll have a quick overview on back pay as well later in the article to understand retro pay better.

The following scenarios may necessitate the need of a retroactive payment:

  • Raises: Although the employer offered a raise, the rate adjustment may not have been immediately reflected in the company's payroll system.
  • Payroll errors: The employer paid for the incorrect amount of hours or encountered other unanticipated problems.
  • Miscalculations in overtime pay: The employer computed overtime pay wrongly.
  • Multiple pay rates for various positions: If an employee is paid at two separate rates, the employer may have calculated their earnings incorrectly for a particular period.

HR or accounting personnel are generally in charge of cases when retro pay is deemed required. HR specialists connect with workers and assist them in managing their problems, while accounting personnel compute the amount of retro pay owed to the team member.

When is There a Need for Retro Pay?

The following are examples of when retro pay is required to properly recompense an employee:

  • Overtime pay is not taken into account. Depending on the business and where it is located, it may be required to adhere to different overtime compensation rules. When the payroll system fails to calculate overtime compensation accurately, retro pay may be required.
  • Shift differentials are not included on a pay stub. A shift difference occurs when employers incentivize workers to work unpleasant shifts by paying them more for doing so, which is frequently the case with second and third shifts.
  • Commissions are not included in a period's earnings. If a staff member receives additional commissions for their work during a pay period but does not see those commissions on their pay stub, they may be entitled to retro pay.
  • Paychecks do not reflect earned increases or bonuses. If a raise or bonus is given but not accurately calculated or distributed, the company may be required to calculate and deliver retro pay.

Do Court Decisions Require Retro Pay Details?

In case, the company or the employer is not willing to pay the amount to the employee or some other situations arise, he/ she can drag this case to court and get back the retro pay amount.

Following are some situations that can be considered:

  1. Discrimination: Discrimination occurs when one set of employees gets paid more than another because of their race, gender, age, or other protected status
  2. Retaliation: Retaliation occurs when an employer terminates an employee for reporting harassment or for whistle-blowing
  3. Breach of Contract: A breach of contract occurs when a company fails to pay an employee or contractor at the agreed-upon rate
  4. Overtime Violations: Overtime violations occur when an employer fails to account for overtime pay (a common violation).
  5. Minimum Wage Violations: Employers who pay employees less than the minimum wage set out in the Fair Labor Standards Act (FLSA), whether on the books or under the table, are committing minimum wage violations

Difference Between Retro Pay & Back Pay

There are various differences between back pay and retro pay. Back pay and retro pay are two distinct ideas, despite the fact that some people use them interchangeably.

A circumstance in which an employee does not get their due salary from their employer is referred to as back pay. These are the payments that should have been paid to the employee but were not. An employer could do this by paying an employee's unpaid wages, even if the employee should have gotten them in the first place.

In the following cases, an employee may be entitled to back pay:

  • Wages that haven't been paid
  • bonuses that haven't been paid
  • sales commissions that haven't been paid; and
  • hours that haven't been worked

The United States Department of Labor has said that obtaining back pay earnings is subject to a statute of limitations. The statute of limitations is two years. This implies that if an employee does not file a claim for back pay within two years of the day they were meant to receive it, they may lose their right to compensation.

The rationale for the statute of limitations is that beyond that period, the evidence proving the employer's failure to properly pay the employee may be destroyed, or the employer's management/staff may have changed. The statute of limitations is extended to three years in situations of intentional wage breaches.

Retroactive pay, on the other hand, is used to rectify an employee's pay rate. It might also be used to adjust their pay for earlier earnings.

To recap, retroactive pay is usually distributed in the following situations:

  • Pay rises that were forgotten or were given at an inconvenient moment;
  • Errors in payroll and/or accounting; and
  • Overtime pay that was assessed improperly

How Does Retro Pay Impact Taxes?

You must still withhold payroll tax when you pay employees retroactive pay.

Retroactive pay is recognised as extra wages for tax purposes. Employees who earn supplemental salaries receive money in addition to their normal pay.

Because supplemental salaries are not considered normal wages, the mechanism for withholding taxes differs slightly.

You must still collect federal income tax and FICA taxes when making retroactive payments (Social Security and Medicare Taxes).

Since we are talking about federal income taxes, we should have a quick overview of how to calculate the federal income tax.

Federal Income Tax Calculation

The amount of federal income tax withheld is determined by how you pay retro pay. The aggregate and percentage techniques are the two options.

The aggregate approach combines supplemental wages (sometimes known as retroactive pay) with regular wages into a single lump amount.

To put it another way, you can add back pay to an employee's future paycheck. If you choose this option, consult IRS Publication 15 for federal withholding tables. If you offer retroactive pay as a stand-alone payout, on the other hand, you must withhold a flat-rate tax of 22%. The supplemental methodology is what it's called.

Coming to the main part of retro pay, the calculation. Calculating retro pay correctly is very crucial for the employee to provide him/ her with a fair amount. Let’s have an in-depth knowledge of calculating retro pay.

Calculating the Retro Pay

Following are the steps to calculate retro pay:

Step 1: Determine if the pay is hourly or salaried

The first step in calculating an employee's accurate retro pay is to identify whether the individual is paid hourly or has a fixed salary. Reviewing their prior pay stubs or reading their contract might help you with this. If a team member just transitioned from hourly to salary, retro pay may be required, so examine their current contract or verify with their current supervisor. To help you better understand how to compute retro pay, examine the following example throughout these steps:

Lisa, a team member in the production department, received the wrong amount in her salary, according to an accountant at the ABC Company. The accountant finds that Lisa is paid hourly after studying her contract material. Lisa gets paid $19 per hour.

Step 2: Determine if you are eligible for overtime pay

You can establish if an employee is eligible for overtime after ascertaining if they are paid hourly or on a salary basis. Many instances of retro pay are necessitated as a result of retro pay calculation mistakes. Most paid employees are unable to earn overtime, thus this must be taken into account when deciding if they are eligible. Their contract also contains details about overtime compensation.

After ascertaining that Lisa works in the production department of the ABC Company, the accountant discovers that she is entitled to overtime compensation under her contract.

Step 3: Determine which pay periods contain errors

If mistakes happened in many pay periods, make sure you're issuing the right pay to appropriately calculate and distribute the retro pay. When a staff member obtains a raise or promotion, but it does not process in the payroll programme, this might happen. To figure out which pay periods had problems, figure out when the change occurred, and monitor the pay periods that followed. Determine which pay periods the staff member worked enough hours to earn overtime and note those in which they did not receive the necessary amount if there was no change such as a raise or promotion.

Despite the fact that Lisa is qualified for overtime payment, the accountant writes on both the timesheet and the cameras that she only works the required 40 hours each week. Because overtime pay is not an issue, the accountant notes that Lisa received a raise from $19 to $20 per hour in the previous month. The accountant decides that three complete pay periods had problems after tracking the pay periods after the hike.

Step 4: Determine the entire retro pay manually

You can manually compute the difference to determine how much you should disperse to the employee after determining which pay periods contain problems in pay computation. The method for calculating total retro pay is determined by the type of error being corrected and the number of pay periods in which the error occurred.

Lisa worked 40 hours per week for three pay periods, each of which is two weeks long, according to the accountant. The accountant can calculate the total impacted hours using this information.

Hours per week x weeks per pay period x number of pay periods with errors = total affected hours

40 hours per week x 2 weeks per period x 3 pay periods = 240 total hours

The entire amount of retro pay Lisa should receive may be calculated after the accountant understands how many hours she was wrongly paid for. They compute the difference in her hourly salary first, then multiply it by the number of hours affected.

New hourly wage - previous hourly wage = difference in hourly pay

$20 per hour - $19 per hour = $1 per hour

Total affected hours x difference in hourly pay = retro pay

240 hours x $1 per hour = $240 retro pay

Step 5: Withhold the appropriate tax amount

The accountant must still withhold the necessary amount of taxes from the retro pay before distributing it to the team member. Other withholdings that the employee may choose for their regular paychecks should also be considered.

Because Lisa has chosen to have no extra withholdings outside of her taxes, the accountant calculates her total taxes at 14% and determines that 86% of that belongs to Lisa.

Total retro pay x tax per cent not withheld = retro pay after taxes

$240 total retro pay x 0.86 after taxes = $206.40 retro pay

So, this was the step-wise process to calculate the retro pay of an employee.

Final Statement

Payroll errors are uncommon, but they do occur. It's almost always an accident.

Don't be concerned if you make a payroll error. Just make sure you correct your mistake as soon as possible. At the end of the day, you want to treat your employees properly and pay them what they're worth.

How Deskera Can Assist You?

As a business, you must be diligent with employee leave management. Deskera People allows you to conveniently manage leave, attendance, payroll, and other expenses. Generating payslips for your employees is now easy as the platform also digitizes and automates HR processes.

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Key Takeaways

  • In case you pay your employee less than you should have during a pay cycle, you owe them retro pay. This is considered a payroll mistake
  • Retro pay, commonly known as retroactive pay, is amounted to an employee for work done during a former pay period
  • There are certain situations when the employer is needed to pay the retro pay to the employees, like overtime compensation, shift differences, commissions, and bonus
  • An employee can drag his employer to the court in certain situations like discrimination, retaliation, breach of contract, overtime violation, minimum wage violations
  • There’s a difference between retro pay and back pay. Although they are used interchangeable, they are different
  • Back pay is a circumstance in which an employee does not get their due salary from their employer
  • Retro pay impacts the federal income tax and is recognised as extra wages when calculating the taxes
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