What Is Backup Withholding?

What Is Backup Withholding?

Let me explain backup withholding directly: it's a tax applied to your investment income at a set rate when you withdraw it. If a payment isn't normally subject to withholding, the payer has to hold back this tax anyway. This setup makes sure agencies like the IRS or Canada Revenue Agency get the income taxes you owe on your earnings.

You might face backup withholding if you haven't followed the rules on taxpayer identification numbers, or TINs. When you pull out your investment income, the required amount gets sent straight to the government, giving them the funds right away but leaving you with less cash in the short term.

Key Takeaways

Here's what you need to know: the IRS uses backup withholding to collect taxes on income you might have spent before your tax bill arrives. It kicks in at 24% if you give a wrong TIN or don't report certain income. This covers things like interest, dividends, and rents, but skips retirement benefits and unemployment pay.

How Backup Withholding Works

As an investor, you earn income from assets, such as interest, dividends, or distributions. This income is taxable when you receive it, but you only pay the taxes once a year during tax season.

You could end up spending all that income before taxes are due, leaving you unable to pay and the IRS chasing what's owed—which is tough and costly for them. That's why the government sometimes requires financial institutions to withhold backup taxes right when you earn the income.

If you're in a cooperative and get at least $10 in patronage dividends reported on Form 1099-PATR, you might face this too. But some taxpayers are exempt: if you've given your name and SSN on Form W-9, it matches IRS records, and they haven't flagged you for mandatory withholding, you're likely clear.

Withholding Due to Incorrect Information

You could face backup withholding if you didn't provide the right TIN or failed to report dividend, interest, or patronage dividend income to the IRS. This also applies to rents, royalties, profits, commissions, fees, and payments for independent contractor work. Gambling winnings might be included if not already withheld under standard rules.

If you as a contractor or investor don't give the correct TIN for payments reported on Form 1099, the payer must withhold 24%. Payers also withhold if the IRS tells them you've underreported interest or dividends on your returns—in that case, you'll get four notices over 120 days warning about the withholding.

If your 1099 shows backup withholding, you can claim that amount as a credit on your income tax filing for the year.

Withholding Due to Unreported Investment Income

The IRS might impose backup withholding if you or your broker didn't report dividend or interest income from investments. This is rarer now because most brokers report automatically.

If you fail to report or underreport, the IRS sends four notices over seven months to your address, notifying you of upcoming backup withholding.

Is Backup Withholding a Bad Thing?

Backup withholding can be a downside because it locks up your money with the IRS that you could have invested elsewhere. That said, if you're subject to it, you might get some back as a tax refund.

Who Is Exempt From Backup Withholding?

Most American citizens avoid backup withholding if their TIN or SSN is on file with their broker and matches their legal name. Retirement accounts and unemployment income are also exempt.

Who Is Subject to Backup Withholding?

You might be subject if you're a foreign citizen, or an American who hasn't provided the correct TIN/SSN, made the required certifications, or reported all taxable interest and dividends on your return to the IRS.

The Bottom Line

The IRS uses backup withholding on certain investment income to avoid tax shortfalls, but it does tie up funds you could invest. Fortunately, most Americans are exempt as long as their SSN or taxpayer ID is on file and matches the brokerage account holder's info.