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ACLI Suggests Flat Percentage Withholding for Periodic Payments

JUL. 27, 2020

ACLI Suggests Flat Percentage Withholding for Periodic Payments

DATED JUL. 27, 2020
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July 27, 2020

Attn: CC:PA:LPD:PR (REG-100320-20)

Kara M. Soderstrom
Office of Associate Chief Counsel
Room 5203, Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

RE: ACLI Comments on Notice of Proposed Rulemaking: Income Tax Withholding on Certain Periodic Retirement and Annuity Payments Under Section 3405(a). (REG-100320-20) (“Proposed Regulations”)

Dear Ms. Soderstrom:

On behalf of the American Council of Life Insurers (“ACLI”), we are writing with recommendations for Income Tax Withholding on Certain Periodic Retirement and Annuity Payments under Section 3405(a) (REG-100320-20) (“Proposed Regulations”). Our recommendations offer reasons as to why the Proposed Regulations should be modified to best address issues unique to our industry and to periodic retirement and annuity payments, generally.

Background

The Proposed Regulation seeks to update certain provisions of Treasury Regulation section 35.3405-1T that apply to periodic payments under certain qualified retirement plans and commercial annuity contracts to conform those provisions to a change to section 3405(a)(4) of the Internal Revenue Code (“the Code”) made by section 11041(c)(2)(G) of the Tax Cuts and Jobs Act, Public Law 115-97, 131 Stat. 2054 (2017) (“TCJA”). Prior to amendment by TCJA, section 3405(a)(4) of the Code provided that, in the case of any periodic payment1 for which a withholding certificate (i.e., IRS Form W-4P) is not in effect, the default rate of income tax withholding is determined by treating the payee as a married individual claiming three withholding exemptions. This default withholding method has been operative for nearly 40 years2.

However, the TCJA, among other changes, eliminated the use of withholding exemptions and, accordingly, amended section 3405(a)(4) to provide that the default rate of withholding on periodic payments is to be determined under rules prescribed by the Secretary of the Treasury. Because of this, section 35.3405-1T currently reflects the old, pre-TCJA default withholding rule and is in need of amendment.

The practical effect of these changes under the TCJA is that they have created a mismatch between the (now defunct) methodology for calculating default withholding on periodic payments and the current, post-TCJA methodology for calculating wage withholding.

To solve for this mismatch, the Proposed Regulation would update and replace the provisions of Q&As a-10, b-3, and b-4 in new Treasury Regulation 31.3405(a)-1 such that “the default rate of withholding on periodic payments is determined in the manner described in the applicable forms, instructions, publications, and other guidance prescribed by the Commissioner.”

Per the preamble to the Proposed Regulation,

This proposed §31.3405(a)-1 provides a flexible and administrable rule that leaves the communication and mechanical details of the default rate of withholding on periodic payments to be provided in applicable forms, instructions, publications, and other guidance. These materials can be updated quickly as needed (for legislative changes or other reasons) to provide payors and plan administrators processing payments adequate time to program their systems to withhold the proper amount of income tax. Currently, withholding on periodic payments, including the default rate of withholding, is explained in the instructions to the 2020 Form W-4P, “Withholding Certificate for Pension or Annuity Payments,” the 2020 Publication 15-T, and related publications. The 2020 Publication 15-T also provides the tables that payors use to calculate withholding on periodic payments (and the tables that employers use to calculate withholding on taxable wages).

While we appreciate and support Treasury and the Service's desire to design a flexible and administrable rule that can be quickly adjusted to changing circumstances, we fear that the ability to nimbly update withholding rules will not necessarily result in adequate time for annuity payors and retirement plan administrators to program their systems to withhold the proper amount of income tax.

There are three principal reasons that the ability to make quick updates does not necessarily translate into adequate time for payors and administrators to program withholding systems and implement process changes.

The first reason is that the withholding rules for periodic payments (and the programming logic supporting those rules) have been in uninterrupted use since 1982 and, consequently, withholding is often administered on in-house, legacy payment systems that are decades-old. This makes reprogramming them complicated, expensive and time-consuming.3

The second reason is that in addition to modifying and testing systems, “payers will need time to update their participant and beneficiary facing forms and notifications, internal policies and procedures, training programs, and quality assurance protocols.” (See footnote 4).

Thirdly, and closely related to the first reason, the payout systems for commercial annuity and retirement plan administration typically stand alone, separate and apart from the payor's employment payroll systems (which are typically out-sourced to a vendor specializing in payroll/wage servicing) and, thus, they cannot piggyback on and leverage such systems.

Recommendation

In a 1987 hearing before the United States Senate Subcommittee on Private Retirement Plans and Oversight of the Internal Revenue Service to discuss IRS Form W-4 (Employee's Withholding Certificate), the Honorable Lawrence Gibbs, Commissioner of the Internal Revenue Service, remarked, “(a)s you know, in our tax system there is a constant tension between fairness and simplicity. In the world of withholding, this translates into tension between accuracy and simplicity.”4

We believe Treasury and the Service can accomplish their stated goal of designing a flexible and administrable rule that provides them with the ability to update withholding quickly, in real time, and that also provides annuity payors and plan administrators with adequate lead time to program their systems and update processes so as to withhold the appropriate amount of income tax. Further, we believe our recommendation can reasonably accommodate what appear to be the competing demands of accuracy and simplicity. Our recommendation is to impose a flat percentage of 10% for default withholding on periodic payments as opposed to running annuity withholding through a complex wage withholding calculation that has multiple moving parts.

The use of a flat 10% default withholding percentage on periodic payments offers several distinct advantages:

1. Our industry is historically adept at administering flat percentage withholding (e.g., 10% withholding on non-periodic distributions; 20% mandatory withholding on eligible rollover distributions; 24% backup withholding; and some of the states require or allow for flat percentage withholding on periodic distributions). This system has worked reasonably well for the IRS, taxpayers and annuity payors.

2. A flat percentage of withholding would allow for more ease in “ever-greening” participant and beneficiary facing forms and notifications, internal policies and procedures, training programs, and quality assurance protocols. In other words, it is easier, relatively speaking, to manage expectation for future change to a flat percentage as opposed to a withholding formula dependent on many moving parts/factors. For example, while the elimination of withholding exemptions has created a square-peg-in-a-round-hole for periodic annuity payment systems, a future rate switch from 10% to, say, 15% should not be nearly as disruptive or complex.

3. Further to the 2nd advantage discussed above, similar efficiencies should inure to Treasury and the IRS in terms of maintaining and updating their forms, notices, policies and procedures.

4. Flat percentage withholding is taxpayer-friendly: it is more easily understood by and transparent to taxpayers than wage withholding.5 Further, use of 10% withholding for periodic payments would align with withholding on non-periodic payments. This would make for an easily applied “eyeball test” whereby users could quickly ascertain whether the correct withholding rate was being applied to a payment, i.e., distributions at 10%; eligible rollovers at 20%; and backup withholding at 24%.

5. According to the 2020 IRS Form W-4P, default withholding is generally not triggered until the taxable amount of the payee's pension or annuity is at least $2,095 a month, thus imposition of a flat 10% should not result in less tax ultimately being withheld. If anything, it may result in increased withholding for the Treasury to the extent withholding applies at a lower dollar threshold.

In sum, imposition of flat default withholding of 10% on periodic payments under section 3405 can provide all stakeholders — Treasury, the Service, annuity & retirement plan payors, and taxpayers — with a simple, transparent, flexible, easily maintained, and accurate methodology for computing withholding on periodic payments under section 3405.

In the alternative, should Treasury and the Service proceed with a wage withholding methodology modified for the TCJA, we would propose recommendations similar to those made by the ABA, namely:

1. The effective date of any new default tax withholding rate should be a January 1st at least two full years after the end of the 2020 calendar year (or a January 1st at least two full years after the end of the calendar year for which Form W-4P is revised to mirror Form W-4, if later). This would give payers enough time to design, program, build, test, debug, and implement any necessary systemic modifications. At a minimum, payers need at least 18 months to complete these steps. In addition, payers need time to update their participant and beneficiary facing forms and notifications, internal policies and procedures, training programs, and quality assurance protocols.

2. Any new default tax withholding rate on periodic pension and annuity payments should apply prospectively only.

3. A midyear effective date should be avoided for any new default tax withholding rate on periodic pension and annuity payments.

4. A midyear implementation deadline should be avoided for any revised version of Form W-4P that reflects changes made to Form W-4 in light of the Tax Cuts and Jobs Act, as described in section II of Notice 2020-3.

* * *

Thank you for considering our comments on this matter. The ACLI would be pleased to answer any questions you may have about this submission.

Sincerely,

Regina Y. Rose

Mandana Parsazad

The American Council of Life Insurers
Washington, DC

The American Council of Life Insurers (ACLI) is the leading trade association driving public policy and advocacy on behalf of the life insurance industry. 90 million American families rely on the life insurance industry for financial protection and retirement security. ACLI’s member companies are dedicated to protecting consumers’ financial wellbeing through life insurance, annuities, retirement plans, long-term care insurance, disability income insurance, reinsurance, and dental, vision and other supplemental benefits. ACLI’s 280 member companies represent 94 percent of industry assets in the United States.

FOOTNOTES

1Reg. Section 35.3405-1T relates to withholding on pensions, annuities and certain other deferred income (Temporary) and provides:

Q-9. What is a periodic payment?

A-9. A periodic payment is an annuity or similar periodic payment whether paid by a licensed life insurance company, a financial institution, or a plan. The term “annuity” means a series of payments payable over a period greater than one year and taxable under section 72 as amounts received as an annuity, whether or not the payments are variable in amount.

Q-10. How will Federal income tax be withheld from a periodic payment?

A-10. In the case of a periodic payment, amounts are withheld as if the payment were a payment of wages by an employer to the employee for the appropriate payroll period. If the payee has not filed a withholding certificate, the amount to be withheld is calculated by treating the payee as a married individual claiming three withholding allowances.

2As noted in the Preamble to the Proposed Regulation, emphasis added:

The Treasury Department and the IRS have issued several sets of regulations under section 3405 that provide guidance regarding withholding on periodic payments, nonperiodic distributions, and eligible rollover distributions. On October 14, 1982, the Treasury Department and the IRS issued §35.3405-1T (TD 7839) (47 FR 45868), which provides general rules addressing withholding requirements and specific rules addressing withholding on periodic payments and nonperiodic distributions (other than eligible rollover distributions), notice and election procedures, and reporting and recordkeeping requirements. On September 22, 1995, the Treasury Department and the IRS issued §31.3405(c)-1 (TD 8619) (60 FR 49215), which provides rules for withholding on eligible rollover distributions, as defined in section 402(f)(2)(A) (generally referring to distributions from plans qualified under section 401(a), section 403(a) plans, section 403(b) tax-sheltered annuity plans, or section 457(b) plans maintained by a governmental employer that are eligible to be rolled over to an IRA (an individual retirement account or individual retirement annuity) or another eligible retirement plan). On February 8, 2000, the Treasury Department and the IRS issued §35.3405-1 (TD 8873) (65 FR 6007), which provides rules regarding the medium through which notices required under section 3405 may be provided. On May 31, 2019, proposed §31.3405(e)-1 was published in the Federal Register (84 FR 25209) to propose rules applicable to periodic payments and nonperiodic distributions (other than eligible rollover distributions) that are to be delivered outside the United States and its possessions.

3Footnote 2 in the Preamble to the Proposed Regulation cites to a February 18, 2020 letter from the American Bankers Association (“ABA”) commenting on Notice 2020-3, Interim Guidance on Income Tax Withholding from Retirement and Annuity Distributions. The ABA aptly commented, in part, that:

The effective date of any new default tax withholding rate should be a January 1st at least two full years after the end of the 2020 calendar year (or a January 1st at least two full years after the end of the calendar year for which Form W-4P is revised to mirror Form W-4, if later). This would give payers enough time to design, program, build, test, debug, and implement any necessary systemic modifications. At a minimum, payers need at least 18 months to complete these steps. In addition, payers need time to update their participant and beneficiary facing forms and notifications, internal policies and procedures, training programs, and quality assurance protocols.

5To the extent Treasury and the Service contemplate modernizing withholding elections on periodic payments in general (beyond default withholding for failure to have a withholding election in effect), we would recommend that taxpayers be permitted to elect a flat percentage of withholding as an alternative to or even in lieu of utilizing a form similar to the IRS Form W-4. As discussed above, a flat percentage is more intuitive to a taxpayer than wage withholding and is easier for her to adjust to best meet her income tax circumstances.

END FOOTNOTES

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