Avoiding IRS Underpayment PenaltiesBack to all blogs
- Pay-as-You-Earn System
- Safe Harbor Payments
- Situations Triggering Underpayments
- True Safe Harbors
- Payroll withholding for employees;
- Pension withholding for retirees; and
- Estimated tax payments for self-employed individuals and those with other sources of income not covered by withholding.
Federal law and most states have so-called safe harbor rules, meaning if you comply with the rules, you won’t be penalized. There are two Federal safe harbor amounts that apply when the payments are made evenly throughout the year.
1. The first safe harbor is based on the tax owed in the current year. If your payments equal or exceed 90% of your current year’s tax liability, you can escape a penalty.
2. The second safe harbor—and the one taxpayers rely on most often—is based on your tax in the immediately preceding tax year. If your current year’s payments equal or exceed 100% of the amount of your prior year’s tax, you can escape a penalty, regardless of the amount of tax you may owe when you file your current year’s return. If your prior year’s adjusted gross income was more than $150,000 ($75,000 if you file married separate status), then your payments for the current year must be 110% of the prior year’s tax to meet the safe harbor amount.
Where taxpayers get into trouble is when their income goes up or their withholding goes down for the current year versus the prior year. Examples are having a substantial increase in income, such as when investments are cashed in, thereby increasing income but without any corresponding withholding or estimated payments. Another frequently encountered situation is when a taxpayer retires and their payroll income is replaced with pension and Social Security income without adequate withholding. Taxpayers who don’t recognize these types of situations often find themselves substantially underpaid and subject to the underpayment penalty when tax time comes around.
The bottom line is that 100% (or 110% for upper-income taxpayers) of your prior year’s total tax is the only true safe harbor because it is based on the prior year’s tax (a known amount), whereas the 90% of the current year’s tax amount is a variable based on the income for the current year, and often that amount isn’t determined until it is too late to adjust the prepayment amounts.
That being said, there are times when using the 100%/110% safe harbor method doesn’t make a lot of financial sense. For example, let’s say that in the prior year, you had a large one-time payment of income that boosted up your tax to $25,000, which is $10,000 more than you normally pay. You know that you won’t have that extra income in the current year. Rather than rely on the 100%/110% of prior tax safe harbor, where you’d be prepaying $10,000 more than your current year’s tax is likely to be, it may be appropriate to use the 90% current-year tax safe harbor, determined by making a projection of your current year tax, and as the year goes along, monitoring your income and the tax paid in to be sure you are on track to reach the 90% goal.
Please contact this office promptly if you have a substantial increase in income so that withholding or estimated tax payments can be adjusted to avoid a penalty.