Backup withholding is money deducted for federal income taxes on some payments by banks and other payers. Backup withholding amounting to 24% of a payment may be required if a taxpayer who receives interest or dividend income provided an incorrect Social Security number to the bank or corporation that is paying the income. Money deducted from a payment as backup withholding can be credited to future income taxes.
A financial advisor could help you optimize your investments to lower your taxes.
Backup Withholding Basics
Backup withholding gives the Internal Revenue Service a way to pre-collect taxes that may be due on some interest and other types of payments. Normally, banks, corporations and other payers don’t have to withhold taxes on payments to recipients. However, in some situations the IRS requires them to.
When backup withholding is deducted, the payer sends the amount withheld to the IRS. The IRS applies it to the taxpayer’s future tax liability. The payer also reports withholding to the recipient of the payment, usually using a Form 1099. The taxpayer can then include the amount withheld as taxes already paid for that year. Backup withholding is deducted at a flat rate of 24% of the payment. This percentage was reduced from 28% with the 2018 tax bill.
How Backup Withholding Works
Any time a taxpayer opens a new bank account, makes a new investment or starts receiving payments that are reported on a Form 1099, he or she has to give the payer with a TIN. Often this is provided on a Form W-9, a tax form payers use to request a TIN. The form also requires the taxpayer to certify that he or she is not subject to backup withholding. When this form is filled out accurately and the taxpayer correctly certifies that backup withholding is not applied, no backup withholding occurs.
Most taxpayers are not subject to backup withholding. Common reasons for requiring backup withholding include:
- The taxpayer did not provide a Social Security number or other Taxpayer Identification Number (TIN) on the W-9.
- The taxpayer provided an incorrect TIN.
- The taxpayer has previously under-reported taxable interest or dividend income and the IRS has notified the payer of this.
- The taxpayer failed to certify to the payer that he or she is not subject to backup withholding.
- The taxpayer has previously failed to file a due tax return.
To avoid being subject to backup withholding, taxpayers should be sure to submit accurate W-9 forms to payers, including the correct TIN and to check the box indicating that they are not subject to backup withholding. Taxpayers also should avoid underreporting dividend and interest income.
How to Stop Backup Withholding
To stop backup withholding, the taxpayer has to fix the problem causing it. This may involve supplying a correct and complete W-9 to the payer or reporting and paying taxes on previously underreported dividend and interest income.
After the taxpayer has corrected the problem, the payer should stop withholding the backup amount. This may happen immediately if the issue was a missing or incorrect TIN or failure to certify that backup withholding is not applicable. If the problem relates to previous failure to pay taxes on dividend or interest or file a tax return, the IRS will notify the payer that backup withholding is no longer applicable.
Payments Subject to Backup Withholding
Most payments that are reported in a Form 1099 can be subject to backup withholding. These include:
- Interest payments
- Commissions, fees and other payments to independent contractors
- Royalty payments
Some types of payments are exempt from backup withholding requirements. They include:
- Real estate transactions
- Cancelled debts
- Distributions from Archer MSAs
- Long-term care benefits
- Retirement account distributions
- Employee Stock Ownership Plan (ESOP) distributions
- Unemployment compensation
- Refunds on state and local taxes
- Qualified tuition program earnings
Backup withholding rules may require a payer such as a bank, corporation or employer of independent contractors to withhold 24% of interest, dividend and some other payments to cover potential future tax liabilities. Backup withholding may come into play if a taxpayer provides incorrect or incomplete information on a Form W-9 or has previously underreported taxable income or dividends.
Tax Planning Tips
- A financial advisor can help you determine your tax liability. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s free Paycheck Calculator to figure your take home pay. It works with both salaried and hourly pay jobs, and takes into account federal, state and local taxes.
Photo credit: ©iStock.com/Anchiy, ©iStock.com/PeopleImages, ©iStock.com/kitzcorner