The IRS recently released Notice 2020-3, which provides interim guidance on default federal income tax withholding rates applicable to certain periodic payments of deferred income. The Notice also provides clarity as to how the IRS will accommodate a change that affects the form used to elect federal income tax withholding from wages, but not the form used to make those elections for deferred income distributions.
Generally, deferred income recipients make an affirmative election as to how much (if any) federal income tax is withheld from their distributions. Internal Revenue Code Section 3405(a) sets out the rules applying to these elections, including what happens if an individual fails to make an election. Until 2018, Code Section 3405(a)(4) provided that the default withholding rate, used in the absence of an election, was the rate applicable to a married person claiming three withholding allowances. However, the Tax Cuts and Jobs Act (TCJA) eliminated personal exemptions (upon which withholding allowances were based) and amended Section 3405(a)(4) to require the Secretary of the Treasury establish rules setting the default amount.
Nonetheless, the IRS announced in Notice 2018-14 that the pre-TCJA Code’s default-withholding rate (i.e., the rate applicable to a married person claiming three withholding allowances) would apply. Notice 2018-92 extended that guidance to 2019. Notice 2020-3 announces that the IRS will continue to use this rate in 2020, but is considering whether continued use after 2020 is appropriate. To this end, the IRS is seeking comments on whether a prospective change to the default withholding rate would be administrable. Comments are due February 17, 2020.
As a result of the redesigned 2020 Form W-4 (Employee’s Withholding Certificate), Form W-4P (Withholding Certificate for Pension or Annuity Payments), used by recipients of certain pension, annuity, and other deferred income to elect the amount of federal income tax withholding to be applied to their distributions, will no longer parallel the Form W-4 because the 2020 Form W-4 does not use withholding allowances to determine the proper amount of federal income tax withholding on employee wages (see earlier coverage).
Even though the 2020 version of Form W-4P will not closely resemble the 2020 version of Form W-4, the IRS is taking steps to minimize any administrative headaches for payors of deferred income. Because employers may continue to rely on pre-2020 Forms W-4 submitted prior to December 31, 2019, the 2020 edition of Publication 15-T will contain withholding tables and computational procedures that apply to both old and new Form W-4s. Payors of deferred income may use the tables and procedures applicable to pre-2020 Form W-4s for making withholding determinations based on the 2020 Form W-4P.