For custodians and trustees of individual retirement accounts (IRAs), federal income tax withholding, as it pertains to distributions, is a major responsibility. Failing to provide distribution recipients (i.e., owners or beneficiaries) with proper election and notification information, or failing to withhold and/or remit federal income tax when required, may result in a penalty to the financial organization. Additionally, a financial organization, as custodian or trustee, may be held liable for the withholding amount if it fails to withhold when required.
Financial organizations are required to notify IRA distribution recipients of their rights as they relate to federal income tax withholding. Except for the earnings attributable to an excess contribution removed by the deadline, Roth IRA distributions are generally not subject to federal income tax withholding requirements.
Temporary Internal Revenue Service (IRS) Regulation 35.3405-1T provides examples of different methods a payor (e.g., IRA custodian or trustee) may use to satisfy the withholding notice to recipients of periodic payments and nonperiodic distributions. Distributions from traditional IRAs are usually categorized as nonperiodic distributions. On the other hand, distributions from IRA annuities are generally considered periodic distributions. An easy and convenient way to satisfy the withholding notice requirement is to provide distribution recipients with IRS Form W-4P, Withholding Certificate for Pension or Annuity Payments.
Unless an individual makes an affirmative election to waive withholding, nonperiodic IRA distributions to US citizens and resident aliens are subject to federal withholding at a rate of 10 percent. By appropriately filling out Form W-4P an individual can waive withholding, or have 10 percent or more withheld. Several Wolters Kluwer Financial Services’ IRA distribution forms, such as the Traditional IRA Distribution Form, include a substitute Form W-4P that fulfills the withholding notice requirement. This form allows a distribution recipient to make, or change, a withholding election each time he/she takes a distribution. The withholding election, or lack thereof, generally applies to all future distributions, unless later revoked.
The rules also require financial organizations to provide periodic notices informing distribution recipients of their right to change their current federal withholding election. The frequency with which these periodic notices must be provided depends on the frequency of the IRA distributions.
An IRA owner or beneficiary who signs a Traditional IRA Distribution Form for each distribution receives the appropriate notice. However, many IRA owners and beneficiaries authorize their IRA custodian/trustee to administer automatic recurring IRA distributions. An individual can authorize automatic distributions any time, regardless of age, though it is more common for traditional IRA owners upon attainment of age 70½ to authorize automatic distributions when they become mandatory. Wolters Kluwer Financial Services’ IRA Age 70½ Election Form or Traditional IRA Distribution Form can be used by an IRA owner to document his/her request of a financial organization to automatically receive his/her required minimum distribution (RMD) each year, and includes a substitute W-4P for the withholding election applicable to the initial and subsequent distributions.
Revocation of Automatic Distributions
When an IRA owner previously requested a financial organization automatically administer his/her RMD each year, an IRA owner may revoke the distributions at any time by doing so in writing. This would also revoke the withholding election.
The rules require a financial organization to provide an annual federal withholding notice to an individual who takes distributions quarterly or more frequently. A distribution recipient must receive the annual notice with adequate time to make an election and to provide the information to the financial organization prior to the first distribution during a calendar year, but no more than six months in advance of the first distribution. In other words, if an IRA owner or beneficiary takes distributions annually, quarterly, or monthly, only one withholding notice per year is required.
A financial organization can satisfy the subsequent notice requirement by delivering a new Form W-4P prior to the first distribution each year. Another approach is to send a form that explains the recipient’s withholding election options. The Wolters Kluwer Financial Services’ Notice of Withholding will fulfill this requirement. Because these are follow-up notices, it is not necessary for the recipient to return it unless he/she wants to change his/her current election, or financial organization policy requires it.
For individuals taking distributions less frequent than quarterly, a financial organization must provide a notice prior to each distribution, but no more than six months in advance. Again, the Wolters Kluwer Financial Services’ Notice of Withholding will fulfill this requirement, and the notice need not be returned to the financial organization unless the recipient wants to change his/her current election, or financial organization policy requires it.
A financial organization may not aggregate withheld nonpayroll amounts (e.g., IRA distribution and backup withholding) with payroll withholding for depositing or reporting purposes. Financial organizations that withhold federal income tax on nonpayroll items must file IRS Form 945, Annual Return of Withheld Federal Income Tax, by January 31 following each year taxes are withheld. According to the Instructions for Form 945, a financial organization must deposit federal income tax withheld by using the Electronic Federal Tax Payment System (EFTPS). The instructions also identify the frequency (semiweekly or monthly) with which a financial organization must remit withheld funds.
If a distribution recipient fails to make a withholding election, 10 percent withholding is mandatory. Failure to provide IRA distribution recipients with the opportunity to make a federal income tax withholding election, or provide a proper notification for a previously made federal income tax withholding election, could result in a $10 penalty per failure – with a maximum of $5,000 per year under Internal Revenue Code Section 6652(h). Additionally, a financial organization could be held liable for payment of the withholding amount. That’s right—the financial organization may be required to pay the withholding amount to the IRS with its own funds. Penalties also apply if withheld amounts are not deposited in a timely manner. These penalties range from 2 percent to 15 percent, depending on how late the payment is. Additionally, a penalty of up to 25% of any unpaid tax could apply if Form 945 is not filed timely. In general, these penalties could be waived if due to reasonable cause.
Clearly, it is essential that financial organizations pay close attention to the federal withholding requirements. From providing an initial notification allowing a traditional IRA owner or beneficiary to make a withholding election, to the subsequent notice and remittance requirements, IRA custodians and trustees will want to clearly understand the federal withholding process. Additionally, accurately documenting the process and making it easy to follow will help maintain consistent procedures and avoid penalties. While not mentioned above, the federal income tax withholding process should also be accompanied by a state income tax withholding process, if applicable.
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