Filling in your tax information each year is not exactly a task that many of us look forward to but it is something that you clearly have to get right before submitting to the tax authorities, and it also makes sense to take advantage of allowances to legitimately reduce your tax burden, if possible.

One of the potential consequences of not meeting the rules could be when the IRS decides to apply backup withholding to your investment returns.

What is backup withholding?

In simple terms, it is a tax levied on your investment income and its primary purpose is to give the IRS a mechanism that enables them to collect taxes on investment income that you may have already spent before your tax bill becomes due.

How it works

If you have investments linked to stocks and other assets that might grow in value you are likely to earn income from these assets, which could be in the form of capital gains, dividends, or interest payments.

Although this income would be taxable at the point in time it is received, there is a potential gap in time between receiving this money and accounting for it when doing your taxes.

There is a potential scenario where you could have spent all of your investment income and find yourself in a position where you don’t have the funds available to pay the taxes due when you submit your return to the IRS.

As you would expect, the IRS is not comfortable with the idea of not being able to collect the tax that was owed to them which is where backup withholding comes into play.

The IRS can sometimes request that a financial institution levies the tax due at the point the investment income is earned. This means that what you owe in taxes for this source of income will be taken from you before you have an opportunity to spend it yourself.

It is also used in other situations

Although you would normally expect backup withholding taxes to be applied in relation to investment income there are a number of other payments that you might receive which could also be subjected to this tax treatment.

For instance, if you have received rental income or royalty payments, these are just two situations where your income could be subjected to backup withholding.

If you fail to report the correct income information when filing your taxes and fail to report dividend or interest payments correctly, for instance, you may discover that the IRS decides to apply backup withholding.

The IRS will notify you of their intention to do this and would normally give you 120 days warning of the action they intend to take.
It could be that you might be exempt from backup withholding if you have filled in Form W-9, but it is always a good idea to get professional tax guidance so that you know your options and don’t end up being notified that the IRS intends to apply backup withholding to collect their taxes.

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