IRS Finalizes Regs on Withholding on Periodic Retirement and Annuity Payments

(Parker Tax Publishing October 2020)

The IRS issued a final regulation which provides rules for federal income tax withholding on certain periodic retirement and annuity payments and which implements a change to Code Sec. 3405(a)(4) made by the Tax Cuts and Jobs Act of 2017 (TCJA). While TCJA amended Code Sec. 3405(a)(4) to eliminate the requirement that a payee be treated as a married individual claiming three withholding exemptions when a withholding certificate was not in effect, the regulations continued to reflect the pre-TCJA rule. T.D. 9920.

Background

Code Sec. 3405 provides federal income tax withholding rules for payments of pensions, annuities, and certain other deferred income (retirement and annuity payments). Retirement and annuity payments that are subject to withholding under Code Sec. 3405 include periodic payments, nonperiodic distributions, and eligible rollover distributions.

A periodic payment is defined in Code Sec. 3405(e)(2) as "a designated distribution which is an annuity or similar periodic payment." Subject to certain exceptions, a designated distribution generally is defined in Code Sec. 3405(e)(1)(A) as any distribution or payment from, or under, an employer deferred compensation plan, an individual retirement plan, or a commercial annuity. For this purpose, an employer deferred compensation plan is defined in Code Sec. 3405(e)(5) as any pension, annuity, profit-sharing, or stock bonus plan or other plan deferring the receipt of compensation, and a commercial annuity is defined in Code Sec. 3405(e)(6) as an annuity, endowment, or life insurance contract issued by an insurance company licensed to do business under the laws of any state. Reg. Sec. 35.3405-1T, Q&A a-9, provides that a periodic payment includes an annuity or similar periodic payment, whether paid by a licensed life insurance company, a financial institution, or a plan. It defines an "annuity" as a series of payments payable over a period greater than one year and taxable under Code Sec. 72 as amounts received as an annuity, whether or not the payments are variable in amount.

Before amendment by the Tax Cuts and Jobs Act (Pub. L. 115-97) (TCJA), Code Sec. 3405(a)(4) provided that, in the case of any periodic payment with respect to which a Form W-4P, Withholding Certificate for Pension or Annuity Payments, is not in effect, the amount withheld from the periodic payment is determined by treating the payee as a married individual claiming three withholding exemptions. TCJA amended Code Sec. 3405(a)(4) to eliminate the requirement that the payee be treated as a married individual claiming three withholding exemptions and to provide instead that, in the case of any periodic payment with respect to which a Form W-4P is not in effect, the amount withheld from the periodic payment will be "determined under rules prescribed by the Secretary." However, certain provisions of Reg. Sec. 35.3405-1T continued to reflect the rule under pre-TCJA Code Sec. 3405(a)(4).

Following enactment of TCJA, the IRS issued three notices (Notice 2018-14, Notice 2018-92, and Notice 2020-3) addressing the change to Code Sec. 3405(a)(4). These notices provide that, for years 2018, 2019, and 2020, the default rate of withholding on periodic payments under Code Sec. 3405(a) is based on treating the payee as a married individual claiming three withholding allowances.

In May, the IRS issued proposed regulations (REG-100320-20) under which the default rate of withholding on periodic payments made after December 31, 2020, would be determined in the manner described in the applicable forms, instructions, publications, and other guidance prescribed by the IRS.

The IRS received two comments from practitioners on the proposed regulation. First, the practitioners recommended that the default rate of withholding on periodic payments be a flat 10 percent rate, rather than a rate based on federal income tax withholding on wages, in order to simplify the default withholding rate on periodic payments and provide transparency, flexibility, efficiency, and accuracy. Alternatively, the practitioners suggested that a new default rate of withholding on periodic payments apply prospectively only and have a January 1 (rather than a mid-year) effective date. Further, the practitioners recommended a January 1 effective date that is at least two full years after the end of the 2020 calendar year (or at least two full years after the end of the calendar year for which Form W-4P is redesigned to mirror Form W-4, Employee's Withholding Certificate, if later), in order to provide payors time to update their systems, forms, and procedures.

Final Regulation

Last week, in T.D. 9920, the IRS adopted the proposed regulation as final with no modifications. Responding to the practitioners' comments, the IRS stated that, instead of setting forth a specific default rate of withholding on periodic payments, the final regulation provides a flexible and administrable rule that leaves the communication and mechanical details of the default withholding rate to be provided in applicable forms, instructions, publications, and other guidance prescribed by the IRS. The IRS said that this approach will enable it to make updates more quickly, including to address legislative changes, to provide payors and plan administrators processing payments adequate time to program their systems to withhold the proper amount of income tax.

The IRS further noted that the proposed regulation did not specify an effective date for a new default rate of withholding on periodic payments or how a new default rate of withholding should be applied. The IRS explained that, although the proposed regulation was proposed to apply to periodic payments made after December 31, 2020, this applicability date describes the periodic payments for which the default rate of withholding is determined in the manner described in the applicable forms, instructions, publications and other guidance prescribed by the IRS. The IRS stated that the effective date and application of a new default rate of withholding on periodic payments, like the default rate of withholding on periodic payments itself, would be described in that guidance.

For a discussion of withholding on pensions, annuities, and IRAs, see Parker Tax ¶212,150.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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