Definition of 'Backup Withholding'
Tax that is levied on investment income, at an established tax rate, as the investor withdraws it. Backup withholding helps to ensure that government tax-collecting agencies (such as the IRS or Canada Revenue Agency) will be able to receive income taxes owed to them from investors' earnings. Backup withholding may be applied when an investor has not met rules regarding taxpayer identification numbers (TIN). At the time the investor withdraws his or her investment income, the amount mandated by the backup withholding tax is remitted to the government, providing the tax-collecting body with the required funds immediately, but leaving the investor with less short-term cash flow.
Investopedia explains 'Backup Withholding'
Investors commonly earn income - for example, interest payments, dividends, capital gains - from assets in which they have invested. While this income is taxable at the time it is received, the taxes owed on any calendar year's worth of investment income only come due once every year, during tax season.
Thus, an investor could potentially spend all of his investment income before his annual income taxes come due, leaving him unable to pay taxes, and leaving the IRS with the difficult and expensive job of collecting the taxes owed. It is primarily this risk that motivates the government to sometimes require backup withholding taxes to be levied by financial institutions at the time investment income is earned.