How to Avoid or Reduce Underpayment Penalties

As the end of the year approaches, individuals should make sure that they have pre-paid enough tax for 2012 to ensure they will not be subject to the underpayment penalty for 2012.

You may not realize it, but taking a few minutes to review your estimated tax payments and/or withholding amounts and making adjustments can actually insulate you from, or reduce, any potential underpayment penalties for 2012.

Congress considers our tax system a "pay-as-you-go" system. To facilitate that concept, the government has provided several means of assisting taxpayers in meeting the "pay-as-you-go" requirement. These include:

• 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, he or she can be subject to the underpayment penalty. This nondeductible interest penalty is higher than what you might earn from a bank and is computed on a quarter-by-quarter basis.

Safe Harbor Payments – Federal law and most states have safe harbor rules. There are two federal safe harbor amounts that apply when the payments are made evenly throughout the year:

1. The first safe harbor is based on the tax owed in the current year. If your payments equal or exceed 90% of your current year's tax liability, you can escape a penalty.
   
   
2. The second safe harbor - and the one taxpayers rely on most often - is based on your tax in the immediately preceding tax year. If your current year's payments equal or exceed 100% of the amount of your prior year's tax, you can escape a penalty. If your prior year's adjusted gross income was more than $150,000 ($75,000 if you file with married separate status), then your payments for the current year must be 110% of the prior year's tax to meet the safe harbor amount.

Where taxpayers get into trouble is when their income goes up or their withholding goes down for the current year versus the prior year. An example is having a substantial increase in income, such as when investments are cashed in for a profit, but without any corresponding withholding or estimated payments. Another frequently encountered situation is when a taxpayer retires and his or her payroll income is replaced with pension and Social Security income without adequate withholding. A marital status change, which usually results in a different return filing status, without adjusting withholding or estimated payments is another case. Taxpayers who don't recognize these types of situations often find themselves substantially underpaid and subject to the underpayment penalty when tax time comes around.

Bottom line, 100% (or 110% for upper-income taxpayers) of your prior year's total tax is the only true safe harbor because it is based on the prior year's tax (a known amount). The 90% of the current year's tax amount is a variable based on the income for the current year, and often that amount isn't determined until it is too late to adjust the prepayment amounts.

The underpayment penalties are computed on a quarterly basis. So estimated payments made late in the year can only reduce penalties from the date of the payment forward. However, withholding is treated as paid ratably throughout the year; thus, boosting your withholding at year's end can actually reduce or eliminate penalties for all quarters of the year. So if you are on payroll and have the ability to temporarily increase your withholding for the balance of the year, you have the ability to reduce potential underpayment penalties for the entire year.

If you have questions or would like assistance determining if your withholding and estimated payments are enough to avoid penalties, please give this office a call.

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