Hypothetical.
Suppose I was underpaid from 2020 to now and I get all of my backpay this year. Because the federal income tax is progressive I take a huge tax hit which I think is unfair because that pay should have been stretched out over time. Do I have to report it all to the IRS for the tax year 2024 or can I apportion it out and do amended returns for tax years 2020-2023?
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.
Further googling shows that by “in the year paid”, they mean the year in which you actually received the backpay, not the year(s) it should have been paid. Get $100K in backpay in 2024? You’ll be paying income tax on it when you file in the spring of '25, based on all of your income in 2024. Sucks if you happened to be making a lot more money this year than in the years you were underpaid, but doesn’t look like there’s much to be done about it.
What you need to do about it is negotiate with the employer to gross up the amount to offset the incremental tax.
Note that if we are talking about someone going from 150,000 to 250,000 because of a 100,000 back pay, you’d pay FICA on almost all of it, while when you it all at once most of it will not be subject to FICA.
Your employer, if they agree to compensate you for the tax issue, is going to account for both the income tax and payroll tax impacts.
Cite: I’ve done this calculation several times for employees who have successfully claimed that they were underpaid at two different companies.
(I started writing this before Machine_Elf and Mighty_Mouse posted, so they covered much of it, but here it is anyway)
Lump sum backpay has to be reported in the tax year it was received, not when it was supposed to be earned. I.e. you can’t amend previous years returns. Depending on the reason for underpayment, the employer may be responsible for covering additional taxes caused by exceeding tax brackets.
So if you were paid $40,000 per year you were taxed at 12% on all of that. If you were supposed to be paid $45,000 in 2020-2023, then you have a lump sump of $20,000 coming on top of this year’s $45,000 for a total of $65,000. The tax bracket for $47,151 to $100,525 is 22% so you’d be paying the usual 12% on that first $47,151 and 22% on the remaining $17,849. That’s $3,927 in taxes on the backpay versus $2,400 if those wages were earned each year. I wouldn’t call that a “huge tax hit” but that $1,527 difference should be covered by the employer. Different numbers can make a bigger difference.
Some states have fines and penalties (paid to either the state or the employee) for failure to pay wages. A good employer should be happy to pay only the tax difference, and it’s something that definitely should be negoiated with the employer.
That (fines and penalties) depends hugely on why the back wages weren’t paid.
Because the management ws thieving bastards and just kept wages back from employees because they could? Until they were caught by the state labor wage-and-hour enforcement folks? Fines deserved for sure. Fines levied is often another story.
Back wages owed because a lawsuit about the terms of your employer being acquired by another company 10 years ago was finally settled and total back compensation agreed to, then finally the company and union(s) figured out the correct apportionment to all 150,000 affected current and former employees? Different situation. No fines, no penalties; the information necessary to make the payments is fresh, having just been created.
OASDI is $168,200 maximum, so FICA would only have Medicare after that.
You are a cash basis taxpayer, all income is reportable the year you receive it.
You can ask your employer to withhold extra taxes.
There used to be something called “income averaging”, where you could do some tricks when you had an unusually high income for a single year - it didn’t QUITE equalize things, but reduced the tax hit somewhat. This was eliminated decades ago.
Depending on the reason for the back pay, you may well be able to force the employer to do so (as part of the settlement, or a punishment for the underpayment). Of course the grossed-up amount is also taxable. So if you got an extra 300,000 in back pay, and that causes your income tax to go up by 80,000, they’d need to give you something like 400,000 - 300K + 80K for taxes plus 20K for taxes on the 80K (just pulling numbers out of thin air, but you get the drift). I’ve never had anything of that magnitude, but I have had small bonuses etc. grossed up so that I netted the amount of the bonus, but my taxable income was a little more.
One NICE thing about that is that you’ll hit the Social Security limit that year, so you will pay a lot less in SS taxes than if you’d gotten the money over the previous years.
One NOT nice thing about that is that your income for t he 3 previous years , when going into the SS benefit calculation, will be the original, lower amount, while the high-paid year it would just be the limit (162K or whatever). So that might impact your benefit.
If someone was actually in this situation, you’d want to do some serious accounting to make sure you are truly made whole, including modelling what your SS benefit would be if you’d been paid properly versus getting the delayed back pay. It might not make a huge difference - but don’t give up a dime if you don’t have to.
I thought the vast majority of back wage cases were those closer to minimum wage, who would take multiple years to get to 6-figures.
Any case where your backpay would have been taxed at a lower rate if it been paid on time is a problem. The two lowest cut points this year are $11,600 and $47,150. So if you were paid $9,600 in a year when you were supposed to have been paid $11,600, and they just give you $2K the next year (on top of your correct $11,600 pay), then your $2K in backpay will be taxed at 12% instead of 10%, shortchanging you by $40.
Yeah, I know the OP is a hypothetical, but no where did they indicate this was an executive or higher pay position. I got backpay once, but it wasnt a lot.
Yes, my wife got back pay once for two years of unpaid overtime and it was $1800.
The cases I’ve dealt with are managerial and professional class. Either settlement of legal cases or internal equity reviews to forestall legal claims.
Years ago, my employer’s HR discovered that they had been applying promotion rules incorrectly for a particular category of employees. This had gone on for somewhere between 5 and 10 years, so when HR finally completed their investigation, some of those employees ended up receiving backpay in the tens of thousands of dollars. They also received interest, but I expect many of them ended up paying extra income tax because:
-
the promotions meant that their actual income earned in the year when this was all resolved was considerably higher than it was in the years in which the backpay should have been paid, and
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the large lump sum payout, on top of that larger actual earned income, pushed their taxable income for that year even higher.
The vast majority of Americans work in lower-wage jobs. Everything measured on a per-person basis is skewed to the low end. Including back pay cases and back pay amounts.
My own experience with back pay was either as a union leader or union member. Wherein the union won some grievance or lawsuit against the company over ongoing non-contractual behavior. Or during successful new contract negotiations when some retroactive raises were negotiated which were then paid once the new contract was ratified, signed, etc.
Depending on how that extra money is paid out, 5- and occasionally 6-figure back pay lumps get paid. With a concomitant impact on taxes, 401k, and FICA as described by so many above.
In my wife’s situation (Canada) the union worked without a contract for a year, then the negotiations yielded an amount for back pay. Then managers also received back pay amount for a “retroactive raise” to balance the fact that their employees got the retroactive raise.
I suppose in some situations you could get the employer to spread the amount over an extra year or so, especially if it’s close to Jan 1. It would have to be an interesting amount if splitting in half is a significant savings. I suspect most employers would dislike carrying the debt on the books for multiple years with all the hassle that entails unless it was some massive amount (or especially if it was a massive amount). They probbly wrote off the amount that year and want it off the books.
I have yet to work for an employer (I’ve had quite a few in my career in Finance) who would pay money out earlier than they absolutely had to.
Given the choice of ending the year with a balance sheet showing:
Cash $1,000,000
Payroll Payable ($500,000)
And
Cash $500,000
Payroll Payable $0
I do not know any who would choose the latter. Cash is king.
The latter is what would happen if you paid out half a $1m settlement in December and the former splitting it between payments in December and January.