If you are a W-2 employee, then your employer should be withholding and submitting your taxes each pay period. If you are self-employed or have income other than W-2 income, you might make quarterly tax payments. However, if your employer isn’t withholding enough or your quarterly estimated payments are off, you could end up owing additional taxes when you file your tax return – which in turn could result in penalties for underpayment.
But what if there was a way that you could avoid the underpayment penalty, even if you end up owing additional taxes? Luckily there is! The IRS provides “safe harbor” provisions that offer you protection against underpayment penalties, if the provision rules are followed.
Before diving into the specific rules of the safe harbor provisions, let’s first explore when an underpayment penalty might be incurred.
Underpayment penalties are one of the most common tax penalties incurred on an Individual Return and it is due to the underpayment of taxes throughout the year. The IRS has a “pay-as-you-go” rule when it comes to taxes, which means you are supposed to pay taxes throughout the year as income is earned/received – not make one lump-sum payment at the end of the year or when you file your taxes. The penalty is calculated by determining how much you should have paid each quarter, then multiplying the difference between what you paid and what you should have paid by the effective interest rate for that period.
The underpayment penalty is avoided by withholding taxes from your paycheck or making quarterly payments, or a combination of the two. However, if your withholding and/or estimated payments aren’t enough to cover your total tax liability for the year, the IRS offers two “safe harbor” methods to determine whether you are subject to this penalty. If you meet one of the safe harbor amounts, you will not be charged an underpayment penalty, even if you owe more taxes when filing your return. The 2 safe harbor methods are as follows:
- 90% of current year tax liability: To qualify for this safe harbor amount, you must pay at least 90% of your current year tax amount by 12/31 if paid through withholding or Q4 payment due date (January 15th) if paid through quarterly payments.
- 100% (or 110%) of last year’s tax liability: To qualify for this safe harbor amount, you must pay 100% of the tax you owed for the prior year. However, if your Adjusted Gross Income (AGI) on the prior year return was over $150,000 (or over $75,000 for Single or Married Filing Separately), you must pay 110% of the prior year tax to qualify for this safe harbor amount.
Keep in mind that, if you extended your return (file your return after the April deadline), even if you meet one of the above safe harbor tests, you will still incur late penalties on any payment due with your return. You are still required to pay your entire tax liability by April to avoid late penalties.
If you want to learn more about safe harbor tax provisions and how you might utilize the provisions to avoid underpayment penalties, see this article for a more in-depth explanation of the above information.