Retro pay, or retroactive pay, is the compensation an employer owes an employee due to a payment shortfall during the previous pay period.

Retro pay compensates for the discrepancy between the wages an employee is entitled to and the actual amount they receive. Retro pay rectifies payroll errors such as overlooked raises or miscalculations in overtime pay.

Employers often add retroactive pay to an employee's paycheck because a raise occurred during a pay cycle or because they made an accounting error. 

Examples of retroactive pay

Retro pay is necessary when the previous pay period did not reflect compensation changes. Some examples of global compensation changes requiring retro pay include the following:

  • Pay raises. An employer promises a pay raise, but the employee receives the incorrect amount.
  • Overtime. An employee worked overtime hours, but their employer miscalculates the overtime pay.
  • Commissions. The employer did not pay an employee’s commissions due to a late-paying client delaying available funds. 
  • Bonuses. The employer underpaid an employee bonus. 
  • Payroll processing errors. A payroll or accounting error occurs when processing payroll, resulting in miscalculated earnings. 
  • Shift differentials. An employer fails to pay the promised increased rate for hours worked outside an employee’s regular shift.

Employees can pursue retro pay and take their employer to court for claims, including discrimination, retaliation, breach of contract, and minimum wage or overtime violations.  

Retroactive pay vs. back pay

Retro pay compensates for employee payment shortfalls, while back pay makes up for a pay period where an employee receives no compensation at all.

Retro pay is when an employer underpays an employee for work already performed and must pay the difference between what they paid and what they should have paid. For example, if an employer miscalculates the overtime rate and underpays an employee for their overtime hours, they owe retro pay.

Back pay is unpaid compensation an employer owes an employee, such as unpaid wages, missed hours, unpaid overtime pay, and missed commissions. For instance, if an employee does not receive a paycheck for a pay period in which they worked, the employer owes them back pay.

It's important to note that some jurisdictions may not distinguish between back pay and retro pay. Depending on the country and company, the term retroactive pay may describe the process of any type of employee reimbursement, including back pay.

Is retroactive pay taxable?

Retroactive pay is considered wages, so employees must pay taxes on retro pay just like they would on other income. Employers must apply all applicable payroll tax withholdings, such as social security and federal and local income taxes, to an employee’s retroactive payments.

Is retro pay taxed higher?

Payments from retroactive pay are subject to the same payroll taxes as an employee’s regular wages. Before paying employees their retro payment, be sure to withhold the appropriate payroll taxes as you would from the employee’s regular wages.

In the U.S., the IRS considers retroactive pay as supplemental pay or compensation an employee receives outside their regular salary. To withhold federal income tax from supplemental pay, the employer must either withhold a flat-rate tax of 22% or add the retro payment amount to the employee's normal wages for the following payroll period.

If the employer adds the retro payment to the next paycheck along with the employee’s regular wages, they would withhold federal income taxes from the combined amount just as with normal payroll rather than a flat rate of 22%.

Read more: How to Pay International Employees

How to calculate retro pay

To calculate retro pay, follow these steps:

  • Determine the origin of the payment error and how many pay periods were affected
  • Consider the employee’s compensation type, such as hourly or salaried, and whether they qualify for overtime pay 
  • Subtract the amount the employee received from the amount that should have been paid to determine the total retroactive pay
  • Withhold the appropriate taxes from the retro pay before issuing it to the employee 

How to issue retro pay to employees

Employers must issue retroactive pay to employees to correct payroll errors. Employers should communicate with the employee, quickly correct the error, adjust the employee's next paycheck, and ensure global payroll compliance with local labor laws in different international markets.

Generally, the retro pay is included in the next pay period as miscellaneous income and listed on the employee’s payslip. Alternatively, employers can issue the retro pay as a separate check.

Consider working with an international payroll outsourcing partner to accurately and compliantly pay foreign employees, no matter their location.

Disclaimer: This information does not, and is not intended to, constitute legal or tax advice and is for general informational purposes only. You should contact your attorney or tax advisor to obtain legal and/or tax advice with respect to your particular situation. Only your individual attorney or tax advisor can provide assurances that this information—and your interpretation of it—is applicable or appropriate to your specific situation. All liability with respect to actions taken or not taken based on this information is hereby expressly disclaimed. All content is provided "as is," and Velocity Global makes no representations or warranties concerning this information.

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