What does retro pay mean?
Because every business wants to avoid breaking labor laws and wishes to keep their employees happy, this article will focus on how you can use retroactive payments to alleviate instances of miscalculated employee payments.
What is retroactive pay and when does it need to be used?
Retroactive pay is compensation added to the current paychecks of employees to make up for underpayment in previous pay periods.
Retro pay needs to be applied as soon as an error is discovered in the payment process that led to the worker being underpaid. Let’s look at different payroll errors that can result in retro pay.
What payroll mistakes require retro pay?
Overtime: This is the most common reason retro pay is needed. Overtime hours for hourly employees are paid at a greater rate than normal hours (1.5 times greater). Retro pay fixes this oversight by making up the difference.
Unapplied raises: If an employee is given a pay raise, but the new wage increase isn’t enacted on the pay period on which it’s set to begin, then you’ll have to pay back the difference retroactively and also be sure to apply the new pay wage for future pay periods.
Shift changes: A shortfall in payment can arise when an employee begins a new work schedule and hours are lost in the process. For example, an employee may trade shifts with another worker and work more hours than expected, creating a payment discrepancy that may result in you needing to retroactively compensate.
Furthermore, an employee may pick up shifts outside their normal availability, such as weekends or holidays, resulting in overtime or holiday pay. Retro pay can be used if a mistake comes about in executing the agreement.
Minimum wage neglect: If you don’t stay updated with the minimum wage requirements of your state and adjust your employee wages accordingly, you’ll have to use retro pay to compensate for the owed wages and then ensure the employee is correctly paid going forward.
Wrongful termination: If a termination takes place and it’s ruled a wrongful termination by a court of law, you’ll need to retroactively pay back all missed wages and hire back the employee.
How to calculate retro pay (hourly employees)
The first step to calculating retro pay is establishing the reasons the shortfall occurred. For example, if a shortfall occurred due to unlogged hours and unpaid overtime, then you’ll want to separate these two occurrences out as to not retro pay too much or too little.
After calculating the separate costs, you’ll add them together to determine the total retroactive compensation.
Then, you’ll apply any applicable tax withholdings to the sum to bring you to your final total.
Here’s are examples of calculating retro pay containing various shortfalls:
John is paid every two weeks and has recently been given a raise. He now is getting paid an hourly rate of $20 an hour rather than $18 an hour. His raise was set to begin at the beginning of the next pay period, but was only enacted starting the second week of the pay period.
Furthermore, for the first week of the pay period, he picked up an additional shift and worked 6 hours more than his usual 30, and the extra hours were unaccounted for.
Lastly, in the second week, he worked 48 hours, awarding him 8 hours of overtime that wasn’t properly applied.
According to the paycheck that was sent out, John worked 36 hours during his first week at $18 an hour, and 48 hours his second week, all at $20 an hour, for a grand total of $1608 (before taxes). John and his manager sense something is amiss, and determine that retro pay is needed.
Let’s first look at the different shortfall reasons and calculate them separately:
John had an unapplied wage that needs to be corrected. His new wage was not applied for the first week, so to fix this, we apply the wage and find the difference:
30 x $20 (the correct wage) = $600
30 x $18 (incorrect wage) = $540
= $60 due to John
Moving onto the next issue, we find that John had a 6 hour shift unaccounted for. So, using the correct wage, we simply do the following:
6 x $20 = $120 due to John
Onto the last shortfall, it’s clear that John is missing out on some overtime pay. So, we find the difference between what we should have paid him and the payment that was sent to him:
Eight (8) of John’s second week’s hours were overtime, but were paid at a regular rate, so
8 x $30 (overtime rate) = $240
8 x $20 (incorrect rate) = $160
= $80 due to John
Finally, we add up our totals:
Wage shortfall: $60
Unaccounted shift: $120
Lost overtime: $80
= $260 due to John
There are a variety of different mathematical methods to reach these totals, so feel free to use whichever you find most appropriate. The general method of breaking down the different shortfalls and finding the difference between what should have been paid and what was paid should always be followed.
How to calculate retro pay (salaried employees)
In our next example, John is a salaried employee.
For almost all of 2021, he was paid $53,000 a year, but was given a raise to $57,000 a year that took effect at the beginning of December of 2021. However, due to an unintentional error, it was never applied.
John is due retro pay, so we do the following:
John is paid twice a month, totaling 24 payments a year. Of those 24 payments, 2 of them account for the month in which John’s raise was supposed to be applied.
John’s former rate of pay: $53,000 / 24 = $2,208.33 per payment
John’s new rate of pay: $57,000 / 24 = $2,375.00 per payment
2 x $2,375.00 (the correct wage) = $4,750.00
2 x $2,208.33 (incorrect wage) = $4,416.66
= $333.34 due to John
How does tax withholding apply toward retro pay?
Regardless of hourly or salary, now that you’ve found the difference between the amount John should have been paid and what he was paid in error, all that’s left to do is apply any applicable payroll taxes to this total.
You’re required to withhold any applicable taxes to retroactive pay, just as you would standard pay. These include:
- Federal income tax
- All applicable state or local taxes
- Social Security
- Any employment taxes on your end
If you choose to add the retro pay to a future pay period, you’ll pay taxes normally based on the adjusted gross with the retro pay included.
However, if you pay the retro pay as a standalone payment, it will act as “supplemental wages” and you will need to pay a flat rate tax of 22%.
Retro pay vs. back pay
Retro pay and back pay are often confused due to both of them pertaining to paying back to employees payments that are due to them. But they are not without their important differences.
Retro pay derives from miscalculations: in pay rate, hours worked, type of hours worked, etc.
Back pay derives from payment failures: whether from financial inability, distribution errors, etc.
Determining retro pay involves finding the difference between an incorrect payment sent out and what was supposed to have been correctly paid.
Back pay typically involves paying out entire pay periods and complete pay earnings for an affected period.
How to pay retroactively
There are two main methods in dispersing retroactive payments:
- Pay out the retro pay as a separate payment
- Add the retro pay to the next pay period’s payment
To avoid confusion (on both your end and your employee’s), it’s a good idea to make sure your employee knows what the extra payment is due to them from a previous pay period. In addition, keep track of this transaction by noting “Retro” on the payment and keeping a note of the transaction in your files.
The general consensus is that it’s best to administer retro pay sooner rather than later to avoid upset employees or getting overwhelmed if you’re dealing with multiple shortfalls from multiple employees.
Regardless of which method you take, finding the employee, detailing out what went wrong and the steps you’ve taken to account for it will go a long way in building trust between you and your employees.
Ready to work with a payroll partner who can help you with retro pay?
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