What is Backup Withholding?
When certain kinds of payments, like interest and dividend payments, are made, a percentage of the payment is withheld and paid to the Internal Revenue Service. This is known as backup withholding. Knowing what kinds of investments require backup withholding will help you make good investment decisions.
Backup Withholding Defined
Backup withholding is a specified percentage of an interest or other payment that is held back by the payer to be paid to the Internal Revenue Service. The percentage is currently 28% of the total payment. Backup withholding can apply to most of the different kinds of payments reported on Form 1099 and can include a variety of different types of revenue. Backup withholding ensures that a person pays taxes on these payments. Most taxpayers are exempt from it unless they meet a very specific set of standards.
Types of Payments it Applies to
There are many different classes of payments that backup withholding can apply to. Most are payments that are reported on IRS Form 1099. These include interest payments, dividends, royalties, and rents. Independent contractors may have to do backup withholding on fees and commissions paid to them. Stock and bond transaction payments from brokers may also be subject to this kind of tax withholding. Wages and pension payments are never subject to withholding.
Reasons for Backup Withholding
The IRS requires backup withholding only in certain situations. It is a preventative measure on the part of the IRS to make sure that taxes are paid. Investors earn income from their investments year-round and the taxes are assessed at the time they receive payments. However, taxes on investment income are only due once a year, in April. It is possible that an investor could spend any investment income before taxes come due and therefore be unable to pay the taxes. Rather than have to spend money collecting the taxes, the IRS may withhold taxes on investment income as it is earned.
Situations that Require Withholding
There are a number of income situations in which backup withholding may be initiated by the IRS. First, if the company or other entity that is making the payment does not have a W-9 with a valid Taxpayer Identification Number (TIN) for the payee, they must do backup withholding. Thee company may also be ordered by the IRS to perform withholding if the TIN is incorrect. Certain types of payments always require withholding. Finally, the IRS may order mandatory withholding if a person has underreported income or made some other error.
How to Avoid Backup Withholding
While there are certain situations in which backup withholding is always required, most taxpayers are exempt from backup withholding. Filling out a W-9 form with a valid TIN that matches the one the IRS has on record ensures that they know who got the payment so they can keep track of whether the taxes are paid. Similarly, filing a tax return when required and amending previous years’ tax returns if they underreported interest or dividend income will prevent an individual from having mandatory withholding.
Certain kinds of income may require you to have backup withholding to ensure that you pay taxes on it. Making sure you know when and why backup withholding may be required can help you make better investing decisions. If you have questions about it, talk to your tax professional today.
