Did you ever pay your employees less than what they should have got for a month? If yes, you are an employer who indulged in delayed wage payment for the workers which is due to payroll mistakes done by your HR department. Payroll mistakes do happen in organisations sometimes; the industrialists have to then provide compensation for the same. This is better known as Retroactive pay.
To give you a better idea about this term, we have included the following points in this blog -
- What is retroactive pay?
- Why retroactive pay is needed?
- When retroactive pay is required?
- How to calculate retroactive pay?
- Tax holding for retroactive pay
- Key Takeaways
What is Retroactive Pay?
Retroactive pay or retro pay has been defined as the compensation added to an employee’s paycheck. This compensation is given by the employer to make up for the compensation shortfall reflected in the employee’s previous pay period. According to the labor laws in the US, employers must clear their pending dues of the employees at the earliest to avoid any company complications later.
The retroactive pay is considered to be different from the back pay for an employee. In back pay, the employee has not got reimbursement for the work he has done for a specific period. In opposition to this, retroactive pay happens when there has been a miscalculation of the salary which got reflected in the pay of that period.
Why Retroactive pay is needed?
Retroactive pay is the remuneration difference given to an employee when he has received less than what he should have got for the work performed for a period. It occurs when there is some fault in the payroll due to technical errors or even when HR makes mistakes in calculating payroll. As a result of the mistakes, the correct compensation is not reflected in the payroll The payroll mistakes that require retroactive pay include -
- Overtime: The HR professional forgets to multiple the overtime hours of an employee with 1.5
- Shift Difference: There is a miscalculation in the wages as the HR professional failed to increase the pay for an employee for certain hours even if he was present beyond his regular scheduled shift.
- Commissions: In small businesses, there can be irregular accounting methods if there is a late-paying client. Hence, the employees on the project often receive delayed funds which impact their commissions.
- Raises: Sometimes, HR fails to address the pay raise for an employee and include it into the accounting system. This can compel the employer to use retroactive pay for some time until the concerned employee’s pay rate is adjusted in the system.
When Retroactive pay is required?
If you are an employer who has just started a business or have ventured into a new domain with an innovative startup project, you must know the times when retroactive pay is required. Here is a list of when an industrialist might be required to do retroactive pay adjustments for his employees -
- Miscalculations in wages: Sometimes, the HR department can face miscalculations in the payroll irrespective of how many times they have run the software. Thereby, there is a chance of miscalculations in wages when there is an incorrect pay rate or a wrong number of working hours on the timesheet for an employee.
- Bonuses: When an employee has earned some bonus or incentive for the good work performed, the client or employer announces bonuses for his dedication. However, due to multiple reasons, he might fail to include it in his paycheck. Therefore, the employer must adjust it in the next period for smooth clearances of the transactions.
- Multiple pay rates as per the employee position: If an employer has an employee who works and handles two or more positions in your organization, he is bound to have different pay rates. It is possible that at the time of period paycheck, there is a wrong entry of the rate when the HR runs the payroll.
- Commissions: The sales employees in an organization are often given commissions by the clients for the work performed. However, they often delay the commissions which imply the use of retroactive pay for the employees involved in the project. If the industrialist does not want this to be delayed and insists on clearing the retroactive pay immediately, he must use a draw against the commission system.
- Pay raise: When an employee is promoted to the next level in the organization, it is possible that there have been no changes in the database of the payroll system. Hence, it is very much possible that the HR team runs his payroll system according to the old pay rate which can mean a loss for the employee. As a result, the employer might need to give retroactive pay to the concerned employee until his new paycheck is added to the database.
- Shift differentials: Sometimes, the employees are required to extend their shifts for the completion of projects when there are deadlines. According to the labor law in the US, the employees have a higher pay rate when they work outside their regular business hours; particularly for evening or night shifts. Hence, if an employee has shift differentials for working a few hours post his regular timing for a few days to complete the project, the employer must give the pay rate according to different pay rates.
- Miscalculated overtime earning: According to the US labor law, if an employee works for more than 40 hours in a week at his workplace, then the employer has to give him the excess payment as per the overtime rate for his additional hours. As per the available information, an employee’s overtime payment can get miscalculated by the accounting department due to human errors. The HR might forget to multiply the hourly rate by 1.5 for an employee who has worked overtime - thereby affecting his earnings total!
How to calculate retroactive pay?
Many businessmen who have just entered the market have very little to almost nil knowledge about the calculations related to retroactive pay. To calculate it perfectly, an employer must do a subtraction of what they have paid for the concerned employee from the amount that should have been paid for a specific period.
Retroactive pay = Amount to be paid for Period X - Amount paid for Period X
(Here, X is the number of days for which calculation is being carried out)
An important point here to note is the employer must use the employee’s gross pay for the retroactive pay calculations. He can withhold the taxes later according to his company’s policy before making the final payment.
Let us understand the retroactive pay calculations with examples given below -
- Hourly example -
Let us imagine that an employer has given his employee Sara, a pay increase from 13$ to 15$ per hour for the work he does in his company. Now, assume that this increase should have been put into effect 2 biweekly periods ago. Now, according to the available data, the employee worked for 2 pay periods and was given wages for 160 hours at 80 hours per biweekly pay period. For the calculation of retroactive pay for this concerned employee, you would need the details about his old hourly rate, new hourly rate, the date from which the pay increase should be effective and how many work hours he has worked according to the old rate.
As per the formula, the retroactive pay value would be calculated as
Retroactive Pay = Amount to be paid for 1 hour - Current amount paid 1 hour
Therefore, the retroactive pay = 15 -13 = 2
It means there is a difference of 2$ per hour in the old and new hour rates
160 hours X $2 per hour = $320
Hence, 320 dollars is the retroactive pay that the employer owes to the employee. As this payment is only related to a pay rise, the additional amount to be added to the employee’s paycheck would be only related to the raise. However, if the employee has worked overtime, then the employer must also include overtime wages as per the overtime rates in the concerned employee’s payslip for that particular period.
- Salaried example -
Let us take another example where the employee has received a salary hike. Imagine John has got a salary hike of 5 per cent for the current financial year. As a result, his salary which was 55,000 dollars last year has got a boost to 57,750 dollars per year after the tax deductions. As per the company policy, this new salary for John was to be effective from the last semi-monthly period.
Now, the employer must calculate his retroactive pay using the data such as old annual salary, new yearly salary, the difference in both the salaries and the date of implementation.
The salary for John would be 55,000$ / 12 = 2,292 $ which is the old semi-monthly salary
As per the hike, the new salary would be 57,750$/12 = 2,406.25$ which is the new semi-monthly salary
Now the difference between both the salaries is,
2,406.25 - 2,292 = 114.25
The difference is 114.25$
Hence, the employer must give 114.25$ X 1-semi-monthly pay period which is 114.25$ retroactive pay to John.
Tax holding for Retroactive pay
An employer in the US has to take care of various federal taxes for the smooth running of his organization. He might even be required to withhold certain paychecks to ensure there are no losses to his organization. As per the US government rules, the industrialist in the US must withhold and remit payroll and income taxes on the retroactive pay. He must withhold -
- Social Security and Medicare taxes (FICA)
- State income tax (if applicable)
- Local income tax (if applicable)
- Federal income tax
Some employers also consider retroactive pay as supplemental wages for the employees. As per the rule, an employer can use the percentage method to hold 22 per cent of the compensation for federal income taxes. If the businessman wants to use the aggregate method to calculate retroactive pay and tax deductions, he can withhold taxes on the compensation sum according to the income tax withholding tables available in IRS publication 15. The employer can withhold FICA tax as per the normal regulations of the US government. If there is any confusion, he can approach a tax consultant to have a better understanding of the withholding amount to have clarifications about state and local income taxes rules on retroactive pay.
Retroactive pay can be confusing for employers if there have been no correct updates about the working hours and can add unnecessary complications to the business. When it comes to withholding taxes in these types of payments, it can get even trickier and also become a time consuming process for businessmen. Deskera is an all in one accounting software that helps to have seamless transactions. Our HRMS and payroll section is a self-service portal for the employees that assist to manage the payslips and timely paychecks for the employees.
How Deskera Can Assist You?
As a business, you must be diligent with the employee payroll system. Deskera People allows you to conveniently manage payroll, leave, attendance, and other expenses. Generating payslips for your employees is now easy as the platform also digitizes and automates HR processes.
- An employer must pay the employees if he has failed to clear the wages related to the hike, shift difference, overtime and even client commissions after the committed period. If he fails to start it on the proposed date, it is included in retroactive pay.
- The times when an employer is required to give retroactive pay are shifts differentials, over time, different pay rates for the different positions, a miscalculation in wages, bonuses, commissions and miscalculated overtime earnings.
- The formula for retroactive pay is Retroactive pay = Amount to be paid for Period X - Amount paid for Period X where X is the number of days for which calculation is being done.
- The employers have to give retroactive pay to the employees because they been payroll errors and incorrect working hours entry into the system.
- An employer can withhold a certain amount from the retroactive pay under FICA tax, state income tax, local income tax and federal income tax. The amount to be withheld can be understood from the IRS website.
- If there have been incorrect payroll entries, then calculations of retroactive pay can be confusing for the employers. Hence, they must always consult the tax professionals or those who have good knowledge about retroactive pay before clearing the payments. Purchasing and installing payroll software can assist the HR and accounting team to do error-free calculations for the wages of employees in an organization.