The Internal Revenue Service (IRS) recently issued new optional federal income tax withholding tables to offset potential underwithholding on pensions paid during 2009. The potential underwithholding is an unintended consequence the “Making Work Pay” credit that is part of the American Recovery and Reinvestment Act of 2009.

If you choose to adopt the new withholding tables, you should consider informing your retirees, who in turn can reconsider their current withholding elections. Some employers may choose to retain the prior (February 2009) withholding tables, because they have already made the effort to implement those tables and communicate the consequences to retirees.

Background

In February 2009 President Obama signed into law the American Recovery and Reinvestment Act of 2009 (ARRA). Included in ARRA is the Making Work Pay credit. The credit is an earned income tax credit that lowers federal income tax withholding rates for many taxpayers who receive earned income. Annuity pension payments from a retirement plan are not considered earned income. This means that retirees who have taxes withheld from their pension plan payments, but do not have any earned income, are not entitled to the Making Work Pay credit.

Also in February of this year, the IRS released new withholding tables that apply to all W-2 income and pension plan payments, except for certain lump sum pension payments that are subject to 20 percent federal income tax withholding. Employers and plan sponsors were required to implement the new withholding tables no later than April 1, 2009. The tables reflect the Making Work Pay credit and apply even to pension payments to retirees who are not entitled to the Making Work Pay credit. As a result, using the new withholding tables may cause retirees to underwithhold on their federal income taxes.

New optional withholding tables for 2009

To remedy this situation, in May the IRS released new withholding tables that employers may use to help retirees avoid federal income tax underwitholding in 2009. The IRS discusses the new withholding tables in IRS Notice 1036-P. The notice states that additional amounts may be withheld from pension payments to account for the fact that the payment is not earned income for the credit and therefore not eligible for the Making Work Pay credit. Use of the new optional withholding tables is not mandatory.

The IRS’s Web site contains several frequently asked questions and answers and offers additional information about the Making Work Pay credit that may help retirees understand their withholding obligations on pension payments made during 2009.

Next steps

Many plan sponsors or trustees notified their retirees about the February withholding tables. In IRS Notice 1036-P, the IRS urges plan sponsors and trustees who adopt the optional withholding table to notify retirees of the new withholding table—especially if the retiree submitted an IRS Form W-4P, Withholding Certificate for Pension or Annuity Payments, after the February withholding tables were issued to request additional withholding.

Plan sponsors and trustees are urged to contact retirees to determine if the additional withholding is still desired, or whether the retiree would like to submit a new federal income tax withholding form. The IRS is also conducting general public outreach to pensioners and other affected groups that they should review and if needed adjust their current level of withholding.

For more information, see the Check Withholding to Avoid a Tax Surprise page on the IRS’s Web site.