Now that the year is over, you can make a relatively accurate projection of your income and deductions.  In order to avoid under-withholding penalties, the IRS requires you to have withheld (through paystub withholding, or estimated taxes) the lesser of:

  • 90% of your current tax liability
  • 100% of last year’s tax liability (if your AGI is under $150,000 MFJ, $75,000 Single)
  • 110% of last year’s tax liability (If your AGI is over $150,000 MFJ, $75,000 Single)

If you haven’t passed any of the above “safe harbor” tests, you will need to make an estimated tax payment prior to January 15th to potentially avoid an estimated tax penalty.  Because the IRS requires these payments to be made in a timely fashion throughout the year, making the necessary payment by January 15th may reduce your penalty rather than eliminate it all together.

Who Might be Subject to an Under-Withholding Penalty?

Business Owners

Due to not having taxes withheld on business income, business owners are highly susceptible to paying under-withholding penalties

Retirees

Retirees, and especially first year retirees are susceptible to under-withholding penalties due the majority of their income being investment income.  Unless a sufficient amount of tax is withheld from IRA distributions, pensions, and Social Security, retirees may be subject to estimated tax penalties.

Having an “Off” Year

The IRS safe harbor rules are designed to protect wage earners from paying penalties in years that earned income increases dramatically.  However, if your earned income decreases dramatically, so will your withholding and you will likely not have either 100% or 110% of last year’s tax withheld from your paystub.  It is especially important to estimate your taxes when you are having an off year to avoid getting hit by under-withholding penalties.