Yes, retroactive pay (retro pay) is fully taxable and subject to federal, state, and local income taxes, plus Social Security and Medicare (FICA) taxes, just like regular wages, and is reported on your W-2 as part of your total income for the year it's paid. It's often treated as supplemental wages, potentially taxed at a flat federal rate (like 22%), or added to regular pay and taxed according to your W-4, which might push you into a higher bracket.
The IRS and the SSA consider back pay awards to be wages. However, for income tax purposes, the IRS treats all back pay as wages in the year paid. Employers should use Form W-2, Wage and Tax Statement, or electronic wage reports to report back pay as wages in the year they actually pay the employee.
To calculate retro pay, simply subtract the amount of wages an employee received from the amount of wages they should've received for the work they completed.
As such, back pay is subject to the same taxes in the year it is paid.
You can issue retroactive pay in one of three ways: Issue a lump sum payment on a separate check. Include retro pay in the employee's next paycheck and label the amount as “RETRO”. Add retro pay to their regular pay on their next paycheck—no need to label.
Unlike with supplemental wages, retro pay is subject to standard payroll taxes and deductions. In other words, it's taxed the same way as regular wages. This includes: Federal income tax.
Tax on back pay
Back pay is treated the same as a salary payment. So, tax and NICs will be deducted from this payment through the PAYE system. This should also be displayed under the deductions on the payslip.
Note that the IRS regards retroactive pay increases as supplemental wages, which are wages paid in addition to regular pay. See IRS Publication 15 for details on withholding federal taxes from supplemental wages. States have their own income tax withholding rules for supplemental pay.
Here are the steps to calculate retroactive pay for hourly employees:
SSDI back pay doesn't affect your ongoing monthly benefits. SSI back pay, however, impacts your resources. It may temporarily reduce or eliminate your monthly SSI payment during the exclusion period. Understanding these implications is essential for long-term financial planning after approval.
The IRS $600 rule refers to a change in reporting requirements for third-party payment apps (like Venmo, PayPal) for taxable income from goods and services, where platforms must send a Form 1099-K if you receive over $600 in a year, intended to capture gig economy/side hustle income, though delays and phased implementation have adjusted the timeline, with current rules for 2024 using a higher threshold ($5,000) before fully phasing to $600 for future years, but remember all taxable income, regardless of form, must always be reported.
You can't entirely avoid taxes on a bonus, but you can significantly lower the amount by contributing to tax-advantaged accounts (401(k), IRA, HSA), deferring the bonus to a year you expect to be in a lower tax bracket, or making charitable donations, thereby reducing your taxable income or increasing deductions at tax time.
This method rolls retro pay into the employee's regular paycheck, and the total amount is taxed based on their normal W-4 withholdings—just like you'd handle any other paycheck. That means you're also withholding for: Federal, state, and local income taxes.
Retainer funds are not taxable income until they are earned and transferred to your operating account. This distinction is critical: Unearned Retainers: Remain client property and should not be reported as income. Earned Retainers: Count as income once work is completed, invoiced, and funds are transferred.
Multiply the difference by hours worked: Multiply the amount that was underpaid per hour (step 3) by the total number of hours worked (step 4). The result is the total retroactive pay due to the employee.
Is retroactive pay considered a bonus? No, retroactive pay is not a bonus. However, if you paid an employee a bonus but they didn't receive the correct amount, retro pay might apply. You may pay them the shortfall in a standalone paycheck or include it in their regular paycheck.