Annuity payments and certain other deferred compensation related to retirement plan distributions (including 403(b)s, 457(b)s and qualified plans) require an election for federal tax withholding. Taxpayers determine the amount of federal income tax to be withheld by making the election on Form W-4P, Withholding Certificate for Pension or Annuity Payments or a substitute form. Annuity and retirement payments that are subject to withholding under IRC Section 3405 include periodic payments, nonperiodic distributions and eligible rollover distributions. The Department of the Treasury has issued final guidance regarding withholding to be applied to these distributions.
Changes made by the Tax Cuts and Jobs Act of 2017 (TCJA) apply the default withholding rate rules. In the absence of an election, IRC Section 3405(a)(4) requires a default withholding rate:
the case of any payment with respect to which a withholding allowance certificate is not in effect, the amount withheld under paragraph (1) shall be determined under rules prescribed by the Secretary.
The Federal Register, Vol. 85, No. 191, published on Oct. 1, 2020, provides final regulation regarding the rules for federal income tax withholding on certain periodic retirement and annuity payments under TCJA. The regulation will apply to periodic payments made after Dec. 31, 2020 and applied to the year 2021 and future years. The final regulations made no changes to the interim proposed rules issued in Notice 2020-3.
Before the final regulation, the rate to be applied was the same as a married individual claiming three withholding allowances as the default withholding rate. The final regulations do not provide a federal income tax withholding rate for certain periodic retirement and annuity payments, and the IRS will provide the procedures for determining the default rate of withholding on periodic payments in upcoming publications and other guidance to be released.
Form W-4P, Employees’ Withholding Certificate, will be updated for the changes at some point, but currently will be similar to the 2020 Form W-4P. As noted on the IRS website:
The IRS also intends to provide in the instructions to the 2021 Form W-4P and related publications that the default rate of withholding on periodic payments will continue to be determined by treating the taxpayer as a married individual claiming three withholding allowances.
Taxpayers receiving applicable retirement payments have time before Dec. 31, 2020 to make a withholding change on Form W-4P for the 2021 tax year and to determine withholding of federal income tax from payments of pension, annuity, or other deferred compensation. It will be important for taxpayers to monitor any future changes to the rate of withholding for periodic payments issued by the IRS that may impact those payments.
So, Where Does That Leave Us?
The preamble to the final regulations really says it all! There were only two comment letters, both written by insurance company trade associations. Those letters requested that the IRS use a default equivalent to a flat percentage of 10%. The IRS rejected that suggestion. (It should be noted that this has not been permissible for quite some time.) Now, financial institutions that have routinely defaulted to a flat rate of withholding in the absence of an election must adjust their operations to conform to the confirmation provided in the final regulations. The final regulations continue to gear the default rate for withholding to be the amount as “described in the applicable forms, instructions, publications and other guidance prescribed by the Commissioner.”
If the participant does not designate a withholding amount, it will be based on the “manner described in the applicable forms, instructions, publications, and other guidance prescribed by the Commissioner.” For 2020 and 2021, this translates to “married with three withholding allowances.”
Also, if the taxpayer completes a W-4P (or substitute) and the correct SSN is not entered, the withholding will be based on the taxpayer being single claiming zero withholding allowances, even if they indicate that they waive withholding. (See the instructions for the form W-4P).
Finally, with employer plan audits re-starting in full force, it is crucial to immediately review withholding policies and procedures. This includes the review of appropriate notices and forms to be sure the withholding language is compliant. It is noteworthy that in recent 403(b) and 457(b) audits, the IRS is requesting withholding notices and elections.
Kimberly Flett, CPA, MST, QKA, CHRS, is at ERISA & Tax Financial Services, LLC.
Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA or its members.
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