Backup withholding is a tax applied to certain investment incomes at a predetermined rate when an investor withdraws funds. It ensures that tax-collecting agencies like the IRS receive the taxes owed from these earnings. Backup withholding is enforced under circumstances such as incorrect taxpayer identification numbers (TINs) or unreported income.
Key Takeaways
- Backup withholding involves setting aside funds for tax purposes from withdrawn investment income.
- It ensures that taxes are collected before potential tax bill issues arise for the investor.
- The withholding rate is typically 24% for taxpayers who provide incorrect TINs or fail to report certain incomes.
- Payments commonly subject to backup withholding include interest, dividends, and rents.
- Retirement benefits and unemployment compensation are exempt from backup withholding.
How Backup Withholding Works
Income such as interest payments, dividends, and distributions from investments can be subject to backup withholding. While this income is taxable when received, annual taxes on it come due only once a year. This delay may lead to increased risk of unpaid taxes if the investor spends all their investment income before tax season.
To mitigate this risk, financial institutions may levy backup withholding at the time the investment income is earned. Additionally, income reported on IRS Form 1099-PATR might also be subjected to withholding.
Payments Subject to Backup Withholding
Non-exempt payments commonly subject to backup withholding include:
- Interest
- Dividends
- Government transfers
- Rents
- Royalties
- Commissions
- Gambling winnings
- Patronage dividends
- Payments from brokers on securities transactions
- Payments from fishing boat operators
Withholding Due to Incorrect Information
Taxpayers might attract backup withholding if they fail to provide the correct TIN or if they neglect to report dividend, interest, or patronage dividend income. Unreported rental payments, royalties, commissions, fees, and compensation for work as an independent contractor are also liable to backup withholding.
If someone does not supply the correct TIN to receive 1099-reported payments, the payer must withhold at 24%. Payers must also withhold this amount if notified by the IRS about underreported interest or dividends on tax returns.
Withholding Due to Unreported Investment Income
The IRS may enforce backup withholding if income like dividends or interest remains unreported or underreported. Although less common due to automated reporting by brokerage firms, an investor will receive four notices over seven months before withholding is applied.
Is Backup Withholding a Bad Thing?
While it can limit funds available for investment by tying cash up with the IRS, subjected investors may receive a portion back as a tax refund.
Who Is Exempt From Backup Withholding?
Most American citizens are exempt from backup withholding if their TIN/SSN matches IRS records. Retirement accounts and unemployment income also bypass withholding.
Who Is Subject to Backup Withholding?
You may be subject if you are a foreign citizen or an American who hasn’t supplied the correct TIN/SSN or made proper certifications, or if you have failed to report all taxable interest and dividends on your tax return.
The Bottom Line
The IRS employs backup withholding to ensure tax collection on certain investment incomes, in an effort to prevent tax shortfalls. Fortunately, most individuals are exempt if they provide accurate identification details. However, for those who are not, this practice can affect cash flow but may result in a tax refund later.
Related Terms: withholding tax, investment income, dividends, interest income, taxpayer identification number, Form 1099.
References
- Internal Revenue Service. “Form W-9, Request for Taxpayer Identification Number and Certification”, Page 2.
- Internal Revenue Service. “Backup Withholding”.
- Internal Revenue Service. “Topic No. 307, Backup Withholding”.
- Internal Revenue Service. “Tax Withholding Types”.
