In January 2022, the Internal Revenue Service (IRS) changed the withholding election rules applicable to distributions from pension plans (a term that includes 401(k) plans, money purchase pension plans and defined benefit pension plans). Specifically, the IRS issued a revised Form W-4P, to be used for reporting periodic payments only (such as monthly pension payments) and creating a new Form W-4R, to be used for nonperiodic payments (such as lump sum distributions and eligible rollover distributions). Use of the new forms was optional for 2022 but became mandatory as of January 1, 2023.
Forms W-4P and W-4R (the Forms) are the tax forms prescribed by the IRS on which a participant receiving payments from a pension plan, including a multiemployer pension plan, may elect to direct the plan administrator with respect to the amount of federal income tax to withhold. Historically, plan administrators should have furnished Form W-4P to participants for both periodic payments and nonperiodic payments. Additional guidance on the new Forms W-4P and W4-R can be found in IRS Publications 15-A and 15-T.
Plan administrators may be subject to tax penalties for failure to withhold and deposit tax required to be withheld on periodic and nonperiodic pension distributions. Avoiding this liability requires the plan administrator to furnish participants with the notice, information, and proper and valid election form required for a participant to elect appropriate withholding. A plan administrator that furnishes or accepts an invalid form may be at increased risk for liability.
Tax Withholding Election – Required Notice Requirements
Generally, plan administrators must notify participants of their right to elect to have no federal income tax withheld, their right to change or revoke previous withholding elections, and the potential for penalties if withholding is inadequate.
- For periodic payments, notice of election generally must be provided no earlier than six months before the first payment and no later than at the time of the first payment, with some flexibility for electronic funds transfers. In practice, pension plans typically provide these notices in benefit applications. Notice of election availability and the right to revoke previous elections then must be provided for each subsequent calendar year.
- For nonperiodic payments, notice is generally required at the time of each nonperiodic distribution. However, the IRS has advised that advance notice should be provided to participants to afford them reasonable time to make an election. The IRS further confirmed that providing the requisite notice in a benefits application would satisfy this requirement.
Tax Withholding Election Forms
Plan administrators may provide the current year form or a substitute election form together with the required notices. However, only the form revision prescribed by the IRS in effect for a calendar year should be furnished in that calendar year and given effect by the plan administrator. Plan administrators may use substitute Forms, but the new IRS rules require that any substitute form must essentially reproduce the Forms in order to be considered valid. As described below, reliance on an invalid election form may expose a plan administrator to possible liability and penalties.
Default and Continuous Withholding Elections
If a plan participant does not provide a valid election or fails to provide a correct social security number using the correct form for the year that periodic payments begin or nonperiodic payments are made, then the participant must be treated as not having a valid withholding election on file. In this scenario, the plan administrator must apply the default withholding rules.
- For periodic payments, the Form W-4P provides for the default withholding rate of single with no adjustments (rather than married with three allowances, as was the case prior to 2022).
- For nonperiodic payments, the default withholding rate depends on the form of distribution. For nonperiodic distributions, the withholding rate is 10%. For an eligible rollover distribution, the default withholding rate is 20%.
It should be noted that a participant need not make an annual election for periodic payments. If a participant does not provide the plan administrator with a new election, the plan administrator must honor the previous election on file. If a participant has not made an election following the effective date of the new Form W-4P, the IRS provides a “computational bridge” to enable plan administrators to determine the proper amount of withholding for the current tax year based on 2021 and earlier Forms W-4P.
Additional Notes
There are numerous additional considerations when evaluating compliance with the withholding requirements on periodic or nonperiodic payments. Please contact Morgan Lewis if you have any questions or otherwise require assistance with these tax withholding requirements.