Avoiding Underpayment Penalties

• Posted on April 24, 2008
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• 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.

When a taxpayer fails to prepay a safe harbor (minimum) amount, they can be subject to the underpayment penalty. This penalty is 3 percentage points higher than the federal short-term rate and the penalty is computed on a quarter-by-quarter basis. 

Federal tax law does provide ways to avoid the underpayment penalty. If the underpayment is less than a de-minimis amount, no penalty is assessed. The de-minimis amount is $1,000. This means, if you owe $1,000 or less on your tax return, you will not be subject to the federal underpayment penalty. In addition, the law provides "safe harbor" prepayments. There are two safe harbors:

1. The first safe harbor is based on your total tax in the current year. If your payments equal or exceed 90% of your tax in the current year, you can escape a penalty. 

2. The second safe harbor is based on your total tax in the immediately preceding tax year. If your payments equal or exceed 100% (110% if your prior year’s adjusted gross income was more than $150,000, or $75,000 if married filing separately) of your prior year’s tax, you can escape a penalty.

Example: Suppose your 2010 tax is $10,000, and your 2010 prepayments total $5,800. The result is that you owe an additional $4,200 on your 2010 tax return. To find out if you owe a penalty, see if you meet the first safe harbor exception. Since 90% of $10,000 is $9,000, your prepayments fell short of the mark. You can't avoid the penalty under this exception.

However, the other safe harbor may still apply. Assume your 2009 prior year tax was $5,000 and your 2009 income was $50,000. Since you prepaid $5,800, which is greater than 100% of the prior year's tax of $5,000, you qualify for this safe harbor and can escape the penalty. If your 2009 income exceeded $150,000 (and you didn’t file as married separate), your prepayment target would be $5,500 (110% x $5,000). Having prepaid $5,800, you’d also avoid the penalty.

This example underscores the importance of making sure your prepayments are adequate, especially if you have a large increase in income. This is common when there is a large gain from the sale of stocks, sale of property, when large bonuses are paid, when a taxpayer retires, etc.