Employment/Tax-IRS Issues Letter Discussing Underwithholding of Tax On Pension Payments

In a letter to Senator Richard Lugar (No. 2010-0223, 9/24/10), the Internal Revenue Service (“IRS”) discussed issues pertaining to underwithholding of federal income tax on pension payments.

According to the letter, in February 2009, the IRS revised federal income tax withholding tables for wages paid in 2009, and told employers to begin using them as soon as possible, but no later than by April 1, 2009. The revision was made to reflect the new Making Work Pay Credit (the “MWP credit”), a tax credit against federal income taxes. The credit is generally equal to the lesser of 6.2 percent of earned income or $400 ($800 for married couples filing jointly).

However, pension payments are not earned income for purposes of the MWP credit. In May 2009, the IRS released Publication 4766, Making Work Pay Credit and Form W-4 Employee’s Withholding Allowance Certificate, which included a one page flyer explaining that certain individuals-including married couples and retirees who receive a pension and do not have any wage income, so that they cannot take the MWP credit- might need to adjust their tax withholding before the 2009 tax return filing season to avoid underwithholding under the new tables. Further, to deal with the underwithholding problem, on May 14, 2009, the IRS issued Notice 1036-P, which made available to pension payors a new optional procedure for adjusting withholding. The 2010 federal income tax withholding tables also include the optional adjustment procedure for pension payors. Pension payors have no requirement to use the optional adjustment procedure, and may use only the withholding tables.

For taxpayers not eligible for the MWP credit, the withholding changes may mean a smaller refund for 2009, or even a balance due. A few taxpayers, including those who usually receive very small refunds, could initially incur a penalty if the underpayment is more than the IRS can attribute to the change in the withholding tables. Individuals may owe an underwithholding penalty for 2009 if their unpaid tax liability is $1,000 or more and if their total withholding and timely estimated payments did not equal at least the smaller of 90 percent of their 2009 tax or 100 percent of their 2008 tax. However, if an individual has an underpayment, the IRS will waive all or part of the penalty, if it determines that the adjustments made to the withholding tables in 2009 caused the underpayment. To request a waiver of the penalty, taxpayers must complete Form 2210, underpayment of Estimated Tax by Individuals, Estates, and Trusts.

The letter indicates that taxpayers receiving pension payments should look at IRS guidance (e.g., the IRS withholding calculator on line or Publication 919) to determining if underwithholding will occur in 2010, and may submit a Form W-4P to their pension payor to adjust withholding as necessary.