Backup Withholding - What is it, and how do I take care of it?

by Trent Krassow, ARe, ARM, CMA, EA, MBA

You may have received a notice from your bank or investment company indicating that you were subject to backup withholding. There is often confusion about backup withholding, as many people who get such a notice think they have been tagged by the IRS for audit, or worse, that the IRS is simply seizing their assets. 

Let's look at this closer. The amount of the backup withholding is typically 24% of the earned interest/dividends, not the entire balance. For example, let’s suppose that you have $10,000 in an investment account, and you earn an 8% return, or $800, in a given year. Your backup withholding would be $800 times 24% (800 x .24), or $192. So, your account still went up by a net of $608, and your principle is still intact. Looking at the math of this situation may help alleviate the fear and panic you might have if you receive such a notice from your financial institution. You are basically paying the tax the government estimates you will owe on the investment earnings, and the amount is fully credited to your income tax return when you file (and you would have had to pay taxes on it, anyway, so you are actually not really out any money except for the possible compounding that you may have received during the year on the small amount withheld.) 

While backup withholding is most commonly associated with bank accounts and investment accounts, other types of income may also be subject to the withholding, such as gambling proceeds, royalties received, commissions, and even the fees an independent contractor may earn. However, you may be relieved to know that the IRS has specifically excluded certain types of payments from backup withholding (list per the IRS website): 

  • Real estate transactions

  • Foreclosures and abandonments

  • Cancelled debts

  • Distributions from Archer MSAs

  • Long term care benefits

  • Distributions from any retirement account

  • Distributions from an employee stock ownership plan

  • Fish purchases for cash

  • Unemployment compensation

  • State or local income tax refunds

  • Qualified tuition program earnings

“So, why can’t I just pay my taxes when they are due?” There are usually two distinct reasons why somebody becomes subject to backup withholding: 

  1. Failure to provide a correct Social Security Number (SSN), Employer Identification Number (EIN), or other Taxpayer Identification Number (TIN) to the organization paying you. For example, if you opened an investment account and either didn’t provide your SSN or perhaps the person processing your account misread your handwriting and entered your SSN incorrectly, you may become subject to backup withholding on the interest your account earns.  

  2. If you underreported your interest or dividend income in the past, the IRS may subject you to backup withholding. Put simply, Uncle Sam wants his money, and he is afraid you might lie to him about how much you earned, so he tells the bank to just send him part of your earnings – 24%, actually. 

What should I do if I get a notice of backup withholding?  

  1. Take a deep breath – the IRS is not seizing your bank account. You are simply prepaying the tax on the interest earned. 

  2. Read the notice carefully – was the backup withholding due to an issue with your SSN/EIN/TIN? If so, take the notice to your financial institution, and make sure their records are correct with respect to your SSN/EIN/TIN. Once this is corrected, the issue will usually resolve itself. If already correct, the Social Security Administration or IRS may have incorrect data, and you will probably want to engage a competent Accountant or Attorney to help navigate the bureaucracy, but there is still no need to panic. 

  3. If the backup withholding is due to a previous underreporting of income, you will need to correct any returns on which the interest or dividend income was previously underreported, and of course, pay any tax owed (and then make sure you do not repeat that mistake in the future!) I recommend engaging a competent tax professional to help with such corrections and filing any amended returns. 

A notice of backup withholding is not a cause for panic, but it is a cause for action. Take the time to correct the situation that initiated the withholding in the first place, and like everything else in life, learn from that situation! If you have questions about a notice of backup withholding, please contact our office at 970-352-0661, and one of our professionals would be happy to dig into the specifics to help you straighten things out. 

photo by Cassidy Kelley on Unsplash