# Backup Withholding: Definition, How It Works, and Who Is Subject

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> **Definition**
>
> Backup withholding is money set aside for tax purposes for withdrawn investment income.

## What Is Backup Withholding?

Backup withholding is a tax that is levied on [investment income](https://www.investopedia.com/terms/i/investmentincome.asp), at an established tax rate, as the investor withdraws it. For payments not subject to withholding, payers are required to withhold the tax. Backup withholding helps to ensure that government tax-collecting agencies, such as the [Internal Revenue Service (IRS)](https://www.investopedia.com/articles/personal-finance/082514/how-irs-became-so-essential-and-so-loathed.asp) or the Canada Revenue Agency, will be able to receive income taxes owed to them from investors’ earnings.

Backup withholding may be applied when an investor has not met rules regarding [taxpayer identification numbers (TINs)](https://www.investopedia.com/terms/t/tax-indentification-number-tin.asp). At the time the investor withdraws their investment income, the amount mandated by the backup withholding tax is remitted to the government, immediately providing the tax-collecting body with the required funds but leaving the investor with less short-term cash flow.

### Key Takeaways

*   Backup withholding 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.
*   Backup withholding at a rate of 24% may be applied to taxpayers who provide an incorrect taxpayer identification number or do not report certain types of income.
*   Some payments subject to backup withholding are interest payments, dividends, and rents.
*   Retirement benefits and unemployment compensation are exempt from backup withholding.

## How Backup Withholding Works

Investors commonly earn income—for example, interest payments, [dividends](https://www.investopedia.com/terms/d/dividend.asp), and distributions—from assets they've invested in. While this income is taxable at the time it is received, the taxes owed on a calendar year’s investment income only come due once every year during [tax season](https://www.investopedia.com/terms/t/tax-season.asp).

Investors could potentially spend all of their investment income before the annual [income taxes](https://www.investopedia.com/terms/i/incometax.asp) come due. This could render them unable to pay taxes, leaving the IRS with the difficult and expensive job of collecting the taxes owed. It is primarily this risk that motivates the government to sometimes require backup withholding taxes to be levied by [financial institutions](https://www.investopedia.com/terms/f/financialinstitution.asp) at the time investment income is earned.

Members who receive at least $10 in cooperative patronage dividends, reported on [IRS Form 1099-PATR](https://www.investopedia.com/1099-patr-form-understanding-your-1099-patr-tax-form-4782126), might also be subject to backup withholding as well.

Some taxpayers are exempt from backup withholding. If you've reported your name and [Social Security number (SSN)](https://www.investopedia.com/terms/s/ssn.asp) to the payer with [Form W-9](https://www.investopedia.com/terms/w/w9form.asp) and it matches the IRS documentation and if the IRS has not notified you that you are subject to mandatory backup withholding, you could be exempt.

## Payments Subject to Backup Withholding

For those not exempt, the following are common payment types that could be subject to backup withholding:

*   Interest
*   Dividends
*   Government transfers
*   Rents
*   [Royalties](https://www.investopedia.com/terms/r/royalty.asp)
*   Commissions
*   Gambling winnings
*   Patronage
*   Payments from brokers on securities transactions
*   Payments from fishing boat operators

> **Important**
>
> Backup withholding 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.

## Withholding Due to Incorrect Information

Taxpayers may also be subject to backup withholding if they did not provide the correct TIN or if they did not report dividend, interest, or patronage dividend income to the IRS. Other types of payments also subject to backup withholding include rents, royalty payments, profits, [commissions](https://www.investopedia.com/terms/c/commission.asp), fees, and other payments for work as an [independent contractor](https://www.investopedia.com/terms/i/independent-contractor.asp). Gambling winnings may also be subject to backup withholding if they were not subject to standard gambling withholding.

If a contractor or investor does not provide the correct TIN to receive [payments that are reportable on Form 1099](https://www.investopedia.com/articles/personal-finance/082514/purpose-1099-forms.asp), the payer is required to withhold at a rate of 24%. Payers might also be required to withhold at that rate if the IRS informs them that the payee's underreported interest or dividends on their income tax returns. In such an instance, the tax filer will be notified four times over 120 days of the issue and the intent to institute backup withholding.

If a tax filer’s 1099 indicates backup withholding, that amount can be applied as a credit against any income tax filing for that year.

## Withholding Due to Unreported Investment Income

The IRS may also require backup withholding if you or your [broker](https://www.investopedia.com/terms/b/broker.asp) don't (or didn't) report dividend or interest income received from investments held. This is less common due to automated reporting by most brokerage firms.

If you fail to report or underreported interest or dividends, the IRS will notify you via four notices mailed to your home address over a period of seven months regarding future backup withholding.

## Is Backup Withholding a Bad Thing?

Backup withholding could be a bad thing, since it ties up money with the IRS that could otherwise be used for investment purposes. If you are subject to backup withholding, however, you may receive some of that money back as a tax refund.

## Who Is Exempt From Backup Withholding?

Most American citizens are exempted from backup withholding so long as their tax identification number or social security number is on file with their broker and corresponds with their legal name. [Retirement](https://www.investopedia.com/retirement/how-much-you-should-have-saved-age/) accounts and unemployment income are also exempted.

## Who Is Subject to Backup Withholding?

You may be subject to backup withholding if you are a foreign citizen, or are an American who has not provided your correct TIN/SSN, made the proper certifications, or reported all your taxable interest and dividends on your tax return to the IRS.

## The Bottom Line

The IRS imposes backup withholding on certain investment income to prevent tax shortfalls, but the practice also ties up funds that could otherwise be invested. Thankfully, most Americans are exempted from backup withholding, so long as a Social Security number or taxpayer ID is on file and matches the personal information of the brokerage account holder.

> **Article Sources**
>
> 1.  Internal Revenue Service. "[Form W-9, Request for Taxpayer Identification Number and Certification](https://www.irs.gov/pub/irs-pdf/fw9.pdf)," Page 2.
>     
> 2.  Internal Revenue Service. "[Backup Withholding](https://www.irs.gov/businesses/small-businesses-self-employed/backup-withholding)."
>     
> 3.  Internal Revenue Service. "[Topic No. 307, Backup Withholding](https://www.irs.gov/taxtopics/tc307)."
>     
> 4.  Internal Revenue Service. "[Tax Withholding Types](https://www.irs.gov/individuals/international-taxpayers/tax-withholding-types)."