In the last few weeks I’ve several email and IM conversations with readers who owe tax this year and are concerned they will be penalized for it. In the case of one reader, TurboTax told them they owed a $120 penalty when they didn’t, because he never told the software that he filed last year and didn’t owe any tax.
The income tax system works on a “pay as you go” model, where you pay your income tax over the course of the year as you earn your income. For most employees earning a paycheck, your employer “withholds” this income tax in your paycheck and makes payments on your behalf. For independent contractors who handle their own withholding, you make quarterly estimated income tax payments to cover your obligations.
Common underpayment scenarios: If you don’t think you will ever underpay, think again, there are plenty of common underpayment scenarios. If you sold your house this year, you may have walked away with a large profit that you didn’t pay quarterly estimated income taxes on; should you be penalized? You may have sold a stock you held and managed to squeak out a decent profit; should you be penalized? In both cases, no, and as long as you satisfied the Safe Harbor rules for income tax payment, then you’ll be safe.
A “safe harbor,” in legal terms, is a provision of a regulation that eliminates a party’s liability as long as the party acted in good faith. In the case of income taxes, it’s an amount that protects you from IRS penalties for income tax underpayment.
Income Tax Safe Harbor Rules
The IRS has many Safe Harbor rules but in the case of income tax payments, you will not pay an underpayment penalty for 2010 if:
- You did not have a tax liability in 2011: If you didn’t owe taxes a year ago, then you won’t be penalized for underpayment this year. If you owe this year, this opens you up to potential underpayment penalties when you file next year if you underpay two years in a row.
- Your underpayment is less than $1,000: If you owe $5,000 and you paid $4,001 throughout the year through withholding and estimated payments, then you’re safe.
- You paid within 90% of your actual liability: If you owed $100,000 for 2011 and you made payments throughout the year that amounted to more than $90,001, then you’re safe.
- Through withholding and estimated payments, you paid more than 100% of your 2011 tax liability ($110% if your AGI is greater than $150,000): If you owed $5,000 in income taxes in 2011 and you owe $50,000 for 2012, as long as you paid more than $5,000 in 2012 (and made all your required estimated tax payments) then you will be safe from penalties.
Hopefully that clears up IRS underpayment penalties and the Safe Harbor rules for avoiding the penalty. You can read more about tax withholding and estimated tax in IRS Publication 505 . Tax preparation packages are great, I used TurboTax  all the time when I was doing my taxes, but they can only help you if they know all the information.
(Photo: mlee )