/ Taxes

How to Avoid Underpayment of Tax Penalties

This article will not be about how to properly fill out your W-4 to withhold enough in taxes, but the different ways that you can meet "enough."

From IRS Publication 505

Generally, you won’t have to pay a penalty for [2018] if any of the following apply.

  • The total of your withholding and timely estimated tax payments was at least as much as your [2017] tax. (See Special rules for certain individuals , later, for higher income taxpayers and farmers and fishermen.)
  • The tax balance due on your [2018] return is no more than 10% of your total [2018] tax, and you paid all required estimated tax payments on time.
  • Your total tax for [2018] minus your withholding is less than $1,000.
  • You didn’t have a tax liability for [2017].
  • You didn’t have any withholding taxes and your current year tax (less any household employment taxes) is less than $1,000.

Note: Despite the fact that Pub 505 is, as of this writing, marked as for 2018, it talks about the 2017 penalties. I adjusted all the years in this quote forward one year, which is why all the years are in square brackets.

Note: Just for the 2018 tax year, the IRS is relaxing the 10% requirement in the second bullet to 15%. To use this exception you must file Form 2210 and claim the 85% waiver (see Instructions to Form 2210).

Please pay special attention to when it says timely estimated tax payments. In general, you must pay your annual tax bill in equal amounts over four quarters, and will, for example, owe penalties if you make all your payments in quarter four. Tax paid through withholding is treated as being paid equally throughout the year, while estimated tax payments are for the quarter in which they are paid. This is discussed in more depth in a later section.

For these exceptions to apply, any payments made must have been timely.

Whenever I say "this year" or "this tax year" in this post, I mean the year for which your are filing taxes. So in quarter 1 of 2019, you are filing 2018's taxes. "This year" refers to 2018.

You Paid At Least As Much as the Previous Tax Year's Taxes*

*From IRS Pub 505, it's 110% of last year's taxes for those over $150k Adjusted Gross Income (AGI) ($75k for MFS (married filing separately)), unless you're a farmer or fisherman.

General Rule
In general, you may owe a penalty for [2018] if the total of your withholding and timely estimated tax payments didn’t equal at least the smaller of:

  • 90% of your [2018] tax, or
  • 100% of your [2017] tax. (Your [2017] tax return must cover a 12-month period.)

Higher income taxpayers.
If your AGI for [2017] was more than $150,000 ($75,000 if your [2018] filing status is married filing a separate return), substitute 110% for 100% in (2) under General Rule, later. This rule does not apply to farmers or fishermen.

What constitutes timely means dividing the thresholds of 90% and 100% (or 110% if applicable) by four, and applying it to each quarter. From IRS Pub 505

Minimum required each period.
You will owe a penalty for any [2018] payment period for which your estimated tax payment plus your withholding for the period and overpayments applied from previous periods was less than the smaller of:

  • 22.5% of your [2018] tax, or
  • 25% of your [2017] tax. (Your [2017] tax return must cover a 12-month period.)

Minimum required for higher income taxpayers.
If you are subject to the rule for higher income taxpayers, discussed above, substitute 27.5% for 25% in (2) under General Rule , later.

This method of avoiding the underpayment of tax penalty makes it substantially easier for people who have highly variable income. You don't need to predict your income throughout the year at all.

This also makes it possible to get a substantial interest free loan from the IRS if you have a large increase in income. For example, suppose a graduate student that was earning a stipend of $28,000 graduates and starts a job earning $100,000. This individual can set his/her withholding throughout the year to only meet the tax liability of an income of $28,000, which would be about $1700. Come tax time, he/she would incur a tax liability of about $15,400 (we're ignoring 401(k)s, IRAs, etc. for simplicity), meaning he/she would owe about $13,700.
But if this individual were smart, he/she would take this money that should have been withheld for taxes and puts it in a savings account at 2.5% interest (yes this is possible). earning about $270 (it's not .025*13700 because the contributions are made monthly, not all at once at the beginning of the year).

Of course I don't expect most people to do this.

You Paid At Least 90% of This Tax Year's Liability

Pretty self explanatory, and discussed in detail in the previous section.

As mentioned earlier, just for the 2018 tax year, the IRS is lowering this threshold to 85%.

You Paid Within $1000 of This Tax Year's Liability Via Withholding

Estimated tax payments do not count for this exception.

You Had No Tax Liability the Previous Tax Year

Self explanatory.

You Had No Withholding and Your Current Taxes is Less than $1000

Self explanatory.

Payments Must be Timely, but Withholding is Special

As mentioned earlier, in general you're required to make your tax payments throughout the year. From IRS Pub 505

Required installments—line 18.
Your required payment for each payment period (line 18) is usually one-fourth of your required annual payment (Part I, line 9). This method—the regular method—is the one to use if you received your income evenly throughout the year.
However, if you didn’t receive your income evenly throughout the year, you may be able to lower or eliminate your penalty by figuring your underpayment using the annualized income installment method. First complete Schedule AI (Form 2210), then enter the amounts from line 25 of that schedule on line 18 of Form 2210, Part IV. See Annualized Income Installment Method (Schedule AI) , later.
Payments made—line 19.
Enter in each column the total of:

  • Your estimated tax paid after the due date for the previous column and by the due date shown at the top of the column, and
  • One-fourth of your withholding.

You're not required to use this regular method, which takes your total tax liability for the year and makes a fourth of it due each quarter of the year. Your estimated tax payments are only applied for the quarter in which they were paid, whereas you could have all of your withholding from your paycheck occur in quarter four, and still have it treated as been paid equally in all four quarters. Yes, this does mean you could have less withheld in taxes in the beginning of the year and more withheld at the end of the year. This will work so long as you are still employed during the end of the year.

There is a different method of determining how much you were required to pay each quarter. It's called the annualized income method, and is more complicated. I will not be going into the details of this method, but it takes into account the income earned in each quarter, as opposed to taking your total income and just assuming it was earned equally in all four quarters. It may result in lower penalties paid if your income varied wildly quarter to quarter.

How to Avoid Underpayment of Tax Penalties
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