You may have encountered being asked if you wanted “backup withholding” when doing certain financial transactions. So, what is it?
Backup withholding is when, during a financial transaction, there is a withholding of income taxes – federal or state – from the proceeds of the transaction. These withholdings are credited to the taxpayer’s tax account(s). When the transaction is reported for tax purposes, this amount is treated the same as an estimated tax payment or withholding from a paycheck.
The tax law provides that the payer of the proceeds is responsible for knowing who they are paying. You are required to provide your tax identification number – either a Social Security Number or an Employer Identification Number if a non-individual. If you provide such information, then backup withholding may become optional. And, there are some instances where backup withholding is not required.
If backup withholding is required, the current federal rate is 24 percent. State rates vary depending upon the state. Payments subject to backup withholdings include, but are not limited to, interest, dividends, rents, commissions, gambling winnings, taxable grants, royalty payments, and sale of assets.
If you are receiving the proceeds of a transaction that will incur a significant amount of tax, backup withholding is encouraged because, if you do not have sufficient credits for payments toward your annual tax obligation, you could be subject to underpayment penalties. These penalties can add up quickly. In the event there would be an excess amount withheld, then you would get a refund of the overpayment upon filing your income tax return.