When you get your paycheck, money's already taken out for taxes. However, that's not the case for all income. Some sources of income, like interest or dividends, aren't typically hit with tax withholding. However, in certain cases, the Internal Revenue Service might subject your payments to backup withholding. As of 2013, the backup withholding rate is 28 percent.
When Backup Withholding is Required
Backup withholding is required when the person receiving taxable payments doesn't give a correct taxpayer identification number, such as a Social Security number or employer identification number. For example, say that when you're filling out your application for a bank account, you accidentally forget to include your Social Security number or write in only eight digits. Your bank must take money out of your interest payments for backup withholding. You might also be subject to backup tax withholding if you underreport your taxable income.
Payments Subject to Backup Withholding
Only certain types of payments are subject to backup withholding. According to IRS Publication 1281, these include "interest, dividends, rents, royalties, commissions, non-employee compensation, and other payments including broker proceeds and barter exchange transactions, reportable gross proceeds paid to attorneys, and certain payments made by fishing boat operators." Other payments are never subject to backup withholding, including land sales, foreclosures, canceled debts, distributions from retirement plan, long-term care benefits, unemployment compensation and state and local tax refunds.
Backup Withholding Purpose
The purpose of backup withholding is to make sure that the government is able to collect taxes on all appropriate income, particularly income that isn't usually subject to withholding like interest or stock profits. When a bank pays you interest, it reports the payments to the IRS so the IRS knows to expect to see that interest reported on your tax return. If the bank doesn't have your correct Social Security number, it can't tell the IRS who it paid. The IRS, in turn, doesn't know who to expect to pay the income taxes on the interest payments.
If you find yourself hit with backup withholding, you're ultimately going to be in the same position as you would have been without it -- you just might have to wait a little longer to get your money. When you file your taxes, you get to claim the taxes withheld through backup withholding as payments you made, just like withholding from your paychecks. If more has been withheld than you owe, you get the excess back as a refund.
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