Life Insurance: Back-Up Withholding And Your Responsibility

Backup withholding is a tax levied on investment income at a rate of 24% (or 30% for non-resident foreign persons) that is deducted from payments not otherwise subject to tax withholding. This is done to ensure that government agencies like the IRS receive income taxes owed to them from investors' earnings. It is applied when a taxpayer fails to provide a correct taxpayer identification number (TIN) or does not report certain types of income, such as dividend or interest income. Life insurance proceeds are generally not subject to income tax and are usually received as a lump sum, which means they are not subject to backup withholding. However, if the life insurance is annuitized, it may be subject to income tax and possibly backup withholding if the correct TIN is not provided or certain types of income are not reported.

What is backup withholding?

Backup withholding is a type of federal income tax that is deducted by payers when their 1099 or W-2G payee has failed to provide a valid Taxpayer Identification Number (TIN) or show that they are exempt from backup withholding. It is an action where the Internal Revenue Service (IRS) makes payers, such as banks, deduct a 24% tax from certain kinds of payments to taxpayers who have failed to provide the IRS or payers with needed information and send that amount to the government. It is a way of ensuring the IRS receives the money it is owed by potentially uncooperative taxpayers.

Backup withholding may be applied when a taxpayer has not met rules regarding TINs. It is used by the IRS to make sure it collects taxes on income that an investor may have already spent before their tax bill comes due. It is also used to ensure that the government can collect taxes on all appropriate income, particularly income that isn't usually subject to withholding, like interest or stock profits.

There are two ways someone can become subject to backup withholding:

The backup withholding “B” program applies to taxpayers who fail to provide a correct TIN to entities that pay them. A TIN can be a Social Security Number, an Employer Identification Number, or an Individual Taxpayer Identification Number.

The backup withholding “C” program applies to taxpayers who have unreported interest or dividend income on their federal tax return, or who have accidentally marked themselves as subject to backup withholding due to previous underreporting of income.

Backup withholding can apply to most kinds of payments reported on Forms 1099 and W-2G, including:

• Attorney's fees and gross proceeds such as settlements paid to an attorney
• Interest payments
• Dividends
• Payment Card and Third Party Network Transactions
• Patronage dividends, but only if at least half the payment is in money
• Rents, profits, or other gains
• Commissions, fees, or other payments for work done as an independent contractor
• Payments by brokers/barter exchanges
• Payments by fishing boat operators, but only the part that is in money and that represents a share of the proceeds of the catch
• Royalty payments
• Gambling winnings
• Original issue discount reportable on Form 1099-OID, if the payment is in cash
• Certain government payments

Payments that are excluded from backup withholding include:

• Real estate transactions
• Foreclosures and abandonments
• 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

When is backup withholding required?

Backup withholding is required when a person receiving taxable payments does not give a correct taxpayer identification number (TIN), such as a Social Security number or employer identification number. For example, if you accidentally forget to include your Social Security number or write in only eight digits when filling out a form, backup withholding will be applied to your interest payments.

Backup withholding is also required when a person fails to report or underreports interest and dividend income on their federal income tax return. In this case, the IRS will notify the payer to start withholding on interest or dividends after mailing at least four notices over a 120-day period.

Backup withholding can also be applied if you fail to certify that you are not subject to backup withholding for underreporting interest and dividends.

Backup withholding is not required for all types of payments. Payments that are excluded from backup withholding include retirement account distributions, long-term care benefits, employee stock ownership plan distributions, unemployment benefits, and local and state income tax refunds.

Payments subject to backup withholding

Backup withholding is a 24% tax that is automatically deducted from certain non-payroll income types when a taxpayer has failed to provide the necessary information. This includes providing an incorrect taxpayer identification number (TIN) or failing to report certain types of income.

The following payments are subject to backup withholding:

• Interest payments (Form 1099-INT)
• Certain government payments (Form 1099-G)
• Dividends (Form 1099-DIV)
• Patronage dividends, but only if at least half of the payment is in money (Form 1099-PATR)
• Rents, profits, royalties, other income, gross proceeds paid to an attorney, certain payments by fishing boat operators, or other types of payments (Form 1099-MISC)
• Commissions, fees, or other payments for work performed as an independent contractor (Form 1099-NEC)
• Payments from brokers and barter exchange transactions (Form 1099-B)
• Payment card and third-party network transactions (Form 1099-K)
• Original issue discount, but limited to the amount of cash paid (Form 1099-OID)
• Gambling winnings that aren't subject to regular gambling withholding (Form W-2 G)
• Government transfers
• Payments from fishing boat operators
• Payments from brokers on securities transactions

It is important to note that not all payments are subject to backup withholding. The following payments are excluded:

• Real estate transactions
• Foreclosures and abandonments
• 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

To stop backup withholding, you need to correct the reason you were subject to it in the first place. This can include providing the correct TIN to the payer, resolving any underreported income, and paying the amount owed. If you have overpaid due to backup withholding, you may be able to get a refund when filing your tax return.

Payments not subject to backup withholding

If you are a taxpayer receiving certain types of income payments, the IRS requires the payer of these payments to report them on an information return. The person or business paying you doesn't generally withhold taxes from these types of payments, as it is assumed that you will report and pay taxes on this income when you file your federal income tax return.

Backup withholding is a 24% tax that is automatically deducted from certain non-payroll income when a taxpayer has failed to provide the needed information. This includes failing to provide a correct taxpayer identification number (TIN) or failing to report interest, dividend, or patronage dividend income.

• Real estate transactions
• Foreclosures and abandonments
• 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

If you are subject to backup withholding, you can stop it by correcting the reason you became subject to it in the first place. This can include providing the correct TIN to the payer, resolving the underreported income, and paying the amount owed, or filing the missing returns.

How to stop backup withholding

To stop backup withholding, you must first identify the reason you became subject to it. This could be because you failed to provide a correct taxpayer identification number (TIN) or because you underreported or failed to report income.

If you did not provide a TIN, or provided an incorrect one, you must correct this by providing the correct TIN to the payer. If you receive a notice from a payer notifying you that the TIN you gave is incorrect, you can usually prevent backup withholding from starting or stop it by giving the payer your correct name and TIN and certifying that the TIN is correct. If you receive a second notice from the payer, you will need to provide verification of your correct name and TIN.

If you are subject to backup withholding due to underreported income, you must resolve the underreported income and pay the amount owed. You may need to file missing returns or an amended tax return.

If you became subject to backup withholding accidentally, you should contact the customer service department of the relevant payer institution and see if they can help. They may ask you to send them a new W-9 form to stop backup withholding.

Frequently asked questions