Final Regs Issued Regarding Withholding on Section 3405 Distributions

The IRS has finalized regs under Code Sec. 3405(a) and Code Sec. 3405(b) to amend income tax withholding rules on certain periodic payments and nonperiodic distributions from employer deferred compensation plans, individual retirement plans, and commercial annuities that are not eligible rollover distributions. (TD 10008, 10/18/2024)

In March 2019, the IRS issued proposed regs generally adopting existing guidance provided in Notice 87-7, released in the wake of withholding changes in the Tax Reform Act of 1986. The notice applied to taxpayers who make distributions from deferred compensation plans, individual retirement accounts, or commercial annuities and explained their responsibilities to withhold from such distributions for the payee’s income tax liability under Code Sec. 3405.

The 2019 proposed regs addressed requests for clarifications from stakeholders regarding certain situations, such as when:

• The payee provides the payor with an Army Post Office (APO), Fleet Post Office (FPO), or Diplomatic Post Office (DPO) address; or

• The payee provides the payor with a residence address located within the U.S. but provides payment instructions that request delivery of the designated distribution to a financial institution or other person located outside of the U.S.

With respect to payees with a military or diplomatic post, the IRS determined that designated distributions to personnel or their families should not be treated as delivered outside of the U.S. The regs also requires payors to withhold in certain circumstances when a payee provides a residence address located within the U.S. but also provides payment instructions indicating that the funds are to be delivered outside of the U.S. Withholding also applies for those who have not provided a residential address.

Additionally, the regs clarify the withholding rules do not apply to designated distributions that do not include a distribution that is subject to withholding under subchapter A of chapter 3. For example, the withholding rules don’t apply to a U.S.-source distribution to a nonresident alien from a trust as described in Code Sec. 401(a). Instead, treatment would follow Code Sec. 1441.

Final regs released October 18 adopt the proposed regs without substantive changes and apply to payments and distributions made on or after January 1, 2026. The IRS specified, though, that taxpayers may follow the regs for earlier payments and distributions. Notice 87-7 will not apply to payments and distributions made after December 31, 2025.

For more on the definition of a designated distribution, see Checkpoint’s Federal Tax Coordinator ¶ J-8505.