Recipients of periodic or annuity retirement plan distributions provide a Form W-4P to payors of pension or annuity payments for the correct amount of federal income tax to be withheld from these distributions. (While retirement plan administrators are primarily liable for withholding (and remittance of withholding), under Treasury Regulation § 3405-1T, Q&A 13, this responsibility can be, and commonly is, shifted to the payor.) In response to changes to the withholding rules in the Tax Cut and Jobs Act of 2017 (TCJA), the Internal Revenue Service (IRS) updated Form W-4P in 2022 and mandated the use of the new 2023 Form W-4P as of January 1, 2023.
As part of the updates to the form, the IRS also imposed stringent content requirements on substitute Forms W-4P. Despite an extended rollout of the new Form W-4P (the use of the updated form was optional in 2022 and did not become mandatory until 2023), payors are still wrestling with its implementation and the new rules regarding the use of substitute forms. Below, we highlight some considerations for implementing the 2023 form as well as potential liability for using invalid forms.
New Withholding Rules. The 2022 and later Forms W-4P differ significantly from the 2021 and earlier forms. Changes include the elimination of withholding allowances, creation of an additional filing status (Head of Household), and inclusion of fields addressing tax credits and deductions to assist in determining the proper amount of withholding. (The IRS also issued a new Form W-4R—the withholding certificate for nonperiodic payments and eligible rollover distributions—to reflect changes in the law under the TCJA. Although a discussion of the Form W-4R is beyond the scope of this post, many aspects of this discussion apply equally to the new Form W-4R.)
Soliciting New Forms W-4P. In order to help payees have the correct amount of withholding applied to their benefits, many payors are soliciting new Forms W-4P. While not required, using the new form has the added benefit of making it easier to determine the correct withholding amounts under the tables released by the IRS in 2023 IRS Publication 15-T.
Notably, the regulations require that payees can only provide, and a payor can only give effect to, the Form W-4P revision in effect for the current calendar year. Consequently, any payee submitting a Form W-4P, whether in connection with the commencement of benefit plan payments or to make a change to an existing election, cannot use an outdated form (including a substitute form that fails to comply with the new substitute form requirements).
Validity of Withholding Instructions on Older Forms W-4P. A payee’s Form W-4P stays in effect until the payee changes or revokes it, meaning payors may have 2021 or earlier Forms W-4P on file together with 2022 or later Forms W-4P. IRS Publication 15-T explains how a payor must withhold depending on which year form a payor has on file. If a payee does not provide a valid withholding form, the payor must apply the default withholding rules.
Substitute Forms. Payors can use a substitute Form W-4P but, to be valid, the rules require a near reproduction of the form itself. See IRS Publication 15-T and additional IRS guidance issued last fall. This is a significant change: historically, payors have used substitute forms quite liberally. But the Form W-4P instructions raise the bar on the requirements for a valid substitute form. Use of an invalid substitute form could expose the payor to secondary liability for underwithholding.
Notice Requirements. Long-standing Tax Equity and Fiscal Responsibility Act (TEFRA) rules require payors to notify payees before the first payment, and then annually thereafter, of their right to choose not to have federal income tax withheld or to change their previous withholding election. See Treas. Reg. § 35.3405-1T. While there is no requirement to include a Form W-4P with the TEFRA notice, payors are permitted to do so, and providing a copy of the Form W-4P can facilitate an election of no withholding or an updated election in accordance with the revised withholding rules.
Potential Liability for Underwithholding and Penalties. The Internal Revenue Code (Code) imposes liability on the plan administrator for tax withholding, but the plan administrator can shift this liability to the payor by directing the payor to withhold and providing the information to carry out these withholding obligations. See 26 USC § 3405(d)(2)(A); Treas. Reg. § 35.3405-1T, Q&A 13. This includes liability for any penalties applicable to a failure to deduct and withhold.
For example, Code Section 6662 imposes a 20% accuracy-related penalty on the portion of an underpayment of tax required to be shown on a return when the underpayment is attributable to negligence or disregard for rules or regulations. Payors could be subject to penalties for relying on an invalid Form W-4P to determine withholding amounts that are reported on Form 945, despite clear rules for how withholding is to be calculated and which Form W-4P is required to be used.
As a consequence of the updated Form W-4P rules, any efforts to avoid payee confusion by using old Forms W-4P, or to simplify Form W-4P for participants, may be risky from a federal tax compliance perspective and should be avoided. Morgan Lewis lawyers are available to discuss any questions that arise concerning Form W-4P, including reviewing payee communications and substitute forms.