How can taxpayers avoid underpayment penalties?

As a Certified Financial Planner and Tax Practitioner with over 2 decades in finance and tax, I help clients navigate these rules all the time.

The short answer is, if you owe more than $1000, you could be subject to underpayment penalties. 

But, there are safe harbor rules protect you from penalties.

You can avoid penalties by paying either 90% of your current year's tax or 100% of last year's tax through withholding and estimated payments.  However, if your income exceeds $150,000, that percentage jumps to 110% of last year's tax.  

Here's a few examples, assuming you made over $150,000 in each of the years:

If your total taxes are $40,000 but only $36,000 was withheld from your paychecks, then you would owe $4000.  However, no penalty would apply since 90% of your taxes had been pre-paid.  Most people don't realize there's a simple rule that can help you avoid underpayment penalties.

The following year, you had a one-time event such as an RSU vesting or you exercised some stock options, resulting in a total tax of $80,000, and your employer only withheld $60,000. A common scenario with stock compensation, by the way.

$60k is not 90% of your total taxes, BUT, it is more than 110% of last year's total taxes, so no penalty.

Now if year 3 is just like year 2, you would get dinged with a penalty, because you wouldn't pass either of the safe harbor tests.  Essentially the IRS is saying, we gave you a free pass last year, but not this year.

The solution?  Either increase your tax withholdings at work, or, make quarterly estimated tax payments on April 15, June 15, and September 15, with the final payment due January 15.  Or all at once early in the year.

For help with your tax planning strategy, schedule a call with me via the Schedule A Call link.