Last week I contacted Ally Bank with a last minute change of heart. I had intended to roll our 12 month CD into a 5 year CD upon expiration, but had second thoughts when I saw that Series I Savings Bonds are more attractive than CD rates.

I actually contacted Ally on the renewal date and was thus able to get the money back out without any penalties. I did, however, notice that our “available balance” was lower than our actual balance.

When I asked about the discrepancy, I was told that we hadn’t sent in our signature cards, and were thus subject to backup withholding. Backup withholding? I wasn’t even sure exactly what that is.

I’ve seen the term many times over the years, but have always checked the box saying that I’m not subject to it. I’ve always known that backup withholding is a special form of income tax withholding, but I never really knew when it applied.

What is backup withholding?

Investment income is not typically subject to regular income tax withholding, but it may be subject to backup withholding to ensure that the IRS gets their money. In general terms, most payments that are reported on Form 1099 are potentially subject to backup withholding.

The backup withholding rate is currently 28%, which means that Ally withheld 28% of our interest earned. This amount will be sent to the IRS on our behalf, and will be reported on our 1099-INT at the end of the year.

Since it’s relatively late in the year, and the amount in question isn’t huge, this isn’t a big deal. Sure, we’ll lose the ability to immediately reinvest our interest, but it will be applied to our tax bill when it comes time to file 2009 taxes.

Who is subject to backup withholding?

According to the IRS (but boiled down into plain English) backup withholding applies if any of the following apply:

• You have not given the payer your Tax ID number,
• You have not certified to the payer that this number is correct,
• The IRS has notified the payer than the number is incorrect,
• The IRS has notified the payer to begin withholding because you have not reported all such income in the past, or
• You have not certified that you are not subject to backup withholding

I’m guessing that it’s this last point that tripped us up. I have no idea what the Ally Bank signature cards look like, but I’d be willing to bet that they have a checkbox to certify that you’re not subject to backup withholding.