Preventing IRS Underpayment Penalties

Congress considers our tax system a "pay-as-you-earn" system. To facilitate that principle, the federal government has actually provided a number of ways of helping taxpayers in meeting the "pay-as-you-earn" requirement. These include:

  • Payroll withholding for employees;
  • Pension withholding for retirees; and
  • Estimated tax payments for self-employed individuals and those with other income sources not covered by withholding.

When a taxpayer fails to prepay a safe harbor (minimum) amount, they can be subject to the underpayment penalty. This nondeductible interest penalty is higher than what might be earned from a bank. The penalty is applied quarterly, so making a fourth-quarter estimated payment only reduces the fourth-quarter penalty.

Nevertheless, withholding is treated as paid ratably throughout the year, so increasing withholding at the end of the year can reduce the penalties for the earlier quarters. This can be accomplished with cooperative employers or by taking an unqualified distribution from a pension plan, which will undergo 20% withholding, and after that returning the gross amount of the distribution to the plan within the 60-day statutory rollover limit (but consult this office before utilizing the latter strategy).


Federal law and most states have so-called safe harbor guidelines, indicating if you abide by the rules, you won't be penalized. There are 2 Federal safe harbor amounts that apply when the payments are made evenly throughout the year.

  • The very first safe harbor is based on the tax owed in the current year. If your payments equal or surpass 90% of your current year's tax liability, you can escape a penalty.
  • The second safe harbor-- and the one taxpayers depend on frequently-- is based on your tax in the immediately preceding tax year. If your current year's payments equal or surpass 100% of the amount of your previous year's tax, you can escape a penalty, regardless of the amount of tax you may owe when you submit your current year's return. If your prior year's adjusted gross income was more than $150,000 ($75,000 if you submit married separate status), then your payments for the current year need to be 110% of the previous 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 considerable boost in income, such as when financial investments are cashed in, thus increasing income but without any corresponding withholding or estimated payments.

Another regularly come across situation is when a taxpayer retires and their payroll income is replaced with pension and Social Security income without appropriate withholding. Taxpayers who do not acknowledge these kinds of circumstances typically 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 previous year's overall tax is the only true safe harbor since 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 stated, there are times when utilizing the 100%/ 110% safe harbor technique does not make a great deal of financial sense. For example, let's say that in the previous year, you had a big one-time payment of income that increased up your tax to $25,000, which is $10,000 more than you usually pay. You know that you won't have that additional 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 might be appropriate to use the 90% current-year tax safe harbor, determined by making a forecast 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 quickly if you have a considerable boost in income, so that withholding or estimated tax payments can be adapted to prevent a penalty.

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