Withholding for Local Taxation (market practice)

I believe most, if not all, of the large recordkeepers do not withhold local taxes from plan distributions. I assume that it's just too difficult to track and administer the various local tax withholding laws/rules. I would also think that there may be some preemption arguments because it's disruptive to the uniform administration of retirement plans.

Without doing any research, I would think that some local jurisdictions would specifically require withholding and some may not (or may not have any rule at all).

I'm thinking that the potential liability to a plan sponsor would be low b/c of some combination of the following: (i) the underlying local tax liability belongs to the participant; (ii) it's a low amount; (iii) limited local resources to enforce; (iv) maybe preemption attaches; and (v) market practice of not withholding for local taxes.

Anyone have any thoughts/direction on this issue?

I know some but not all states have mandatory tax withholding on retirement plan distributions, and others have voluntary withholding, and  I have seen where RKs may only accommodate mandatory requirements. I have never run into a situation where there is mandatory tax withholding at a local municipality (e.g., city) level. If there were any, I'd be shocked if any RK accommodated such unless maybe they were also located within such jurisdiction and had the local tax reporting infrastructure already in place.

There are some US cities that have a fixed percent withholding, which is done at the payroll level, probably with no corresponding "tax return".  Just my guess, those local statutes refer to wages, or salary, or overtime, or earned income, or W-2 compensation, or something similar.  That is, it's a tax on wages.  I would be surprised if any referred to payment from a qualified plan.

BTW, the original question appears to assume taxation might apply to a periodic distribution from a DB plan.   If that is subject to taxation, why not some taxation for distribution from a DC plan?  And how would such a statute deal with amounts that are rolled over?  Or made due to death or disability?

Yes, many cities do have a tax on wages taken at the payroll level w/o further tax return needed, except for self-employment income. I know most cities in Ohio have this, which is why I stayed out of the city when I moved. I believe ERISA25 was asking in DCP context as recordkeeper was the reference rather than trustee/custodian/paying agent which I would associate with a DBP.  Regardless, as you note, local taxes likely only apply to wages and not retirement income/qualified plan distributions.

If there was only one local taxing authority that would require withholding of local taxes on retirement income, my guess is it would be New York City.  They do tax retirement income above a certain threshold ($20,000?) and they do expect the taxpayer to make estimated tax payments.

Pennsylvania is another state that allows municipalities, boroughs, and townships (generically termed "political subdivisions) to assess earned income taxes (EIT) and local services taxes (LST).  Taxes are calculated based on place of residence AND work place.  Withholding is mandatory, but fortunately only wages are included in calculating the EIT.  The LSTs commonly are per capita amounts.  The biggest challenge for the entire system is getting the tax withholding credited to the correct taxing authority.

I agree that recordkeepers do not calculate local taxes based on a local tax formula (there probably is an exception), but some recordkeepers alert a participant that a taxable distribution may be subject to state and local taxes and the participant may want to increase the withholding from their distribution.

While not directly on point with local taxes, Vanguard has a detailed summary of state tax withholding rules (attached).

Vanguard - Applicable state tax withholding for retirement plan distributions.pdf