The best time for tax check-ups – and why they matter
Tax pros can help clients make changes before the end of the year to avoid underwithholding and underpayment penalties
Editor’s note: This article has been modified to include updated information following the passage of the 2017 Tax Cuts and Jobs Act.
It’s bad enough to tell a client whose return you have just completed that he has a large balance due, despite your diligent efforts to look for ways to reduce his tax liability. Then, as if unintentionally rubbing salt in the wound, you point out his underpayment penalty.
This article covers our tax system’s pay-as-you-go requirement, how and when an underpayment penalty is triggered, and how a taxpayer might avoid or mitigate the penalty. The focus of this article is federal tax, although the same principles may apply to state taxes.
Pay as you go – the basics
The U.S. tax system is a “pay-as-you-go” system – meaning taxpayers pay their tax liability throughout the year, not on one single day in mid-April. These tax payments may take the form of payroll withholding, estimated payments, or a combination of both.
Employees generally pay their taxes through paycheck withholding, while self-employed taxpayers (filing Schedule C) make quarterly estimated payments. A taxpayer who is an employee and self-employed (such as someone with a side business) can pay his or her taxes both ways, although taxes must be withheld.
If an employee’s income from a side business isn’t substantial, he or she may prefer to simply increase paycheck withholding, rather than make estimated payments. For married taxpayers who both work, the couple may increase withholding from one or both paychecks. This may be more convenient than making estimated payments. However, if the business is generating a large tax liability relative to compensation, the taxpayer may also need to make quarterly estimated tax payments.
Employees don’t have the option of electing out of withholding entirely, to pay their entire tax liability through estimated payments. An employer is required to withhold taxes based withholding rates contained in Circular E, Employer’s Tax Guide. That’s unless the employee claims exemption from withholding because he or she didn’t have a tax liability for the prior year, and expects no tax liability for the current year.
By default, employers typically withhold employee taxes based on employees’ taxable compensation. However, employees may increase their withholding to cover any additional tax liability they create outside of their jobs, such as from business, investment, or rental income; taxable refunds, capital gains, etc. To adjust withholding, the employee should complete a new Form W-4, reducing the number of personal exemptions and/or adding or increasing a fixed amount of taxes to be withheld from each paycheck.
Even though taxpayers who are employees will have taxes withheld, they can also make tax payments through the Electronic Federal Tax Payment System (EFTPS). So, if a taxpayer discovers a big shortfall in late December, he or she can make a tax payment without having to complete a new Form W-4, which wouldn’t likely be effective before the end of the year. There’s no charge to enroll or to make tax payments through EFTPS, which will credit a tax payment on the same day if the payment is made before 8 pm. Taxpayers may want to enroll and have this safeguard in place in case they need to make additional tax payments.
The one major difference between paying taxes through withholding and using EFTPS is that withholding taxes are prorated evenly throughout the year, and the IRS considers EFTPS payments paid as of the actual payment date. This has implications for calculating underpayment penalties, if any are due.
Whether someone pays taxes through withholding or electronically, the challenge is to determine how much to withhold or pay. Completing a new Form W-4 only instructs employers how much to withhold from an employee’s paycheck. Determining the “correct” amount to be withheld is the employee’s responsibility.
Underpayment penalties and safe harbors
The IRS will assess an underpayment (or underwithholding) penalty if, by the end of the year, the tax liability is greater than $1,000 and the taxpayer hasn’t paid at least 90% of the full-year tax liability. There’s another safe harbor for taxpayers who paid at least 100% of the prior-year tax, or 110% of the prior-year tax if their AGI was more than $150,000 ($75,000 for MFS filers).
Other taxpayers who may avoid the underpayment penalty include:
- Fishermen and farmers, who base their tax payments on the prior-year tax liability
- Victims of casualties and disasters
- Taxpayers who become disabled or recently retired
- Workers who receive income unevenly during the year
These groups aren’t automatically invulnerable to underpayment penalties, but they can obtain waivers. Form 2210 instructions explain how to obtain a waiver.
The IRS calculates underpayment penalties for each quarter and the number of days a taxpayer has underpaid his or her liability. The IRS also applies an underpayment interest rate to the number of days the tax liability is underpaid (the rate is now 4 percent).
For whether a new Form W-4 should be filed after Dec. 31, 2017 under the TCJA, see the Tax Information Center article “Should I File a New W-4 Form?”
Just as a pilot begins his descent to the runway miles before reaching the airport, taxpayers ideally will examine their tax situation a few months before year-end. Doing so will help make sure there’s a smooth glide path for withholding enough, without severely disrupting the taxpayer’s cash flow with a big, unexpected tax payment.
What’s the best time to check withholding and estimate tax liability? Big life events, such as a marriage, job loss, or having a child, will impact one’s taxes, so that’s always a good time to reassess one’s tax situation.
Otherwise, early fall is good time for many taxpayers. With three to four months remaining in the year, taxpayers can reasonably project their tax liability, perhaps with help from a tax pro. This timing will also allow enough time to correct any imbalance gradually before the end of the year. The earlier in the year employees adjust their withholding on Form W-4, the more pay periods are affected, so the amount per pay period is smaller.
For example, suppose a taxpayer is informed by his tax pro in late September that his withholding is $2,000 less than his projected tax liability. The taxpayer can then increase his tax withholding by $333 per pay period for the remaining six pay periods before the end of the year. If the taxpayer had learned of this shortfall in late November, he would have only two pay periods remaining to cover the $2,000 shortfall (assuming that the payroll department could implement the higher withholding in enough time).
Salary income + side job
Suppose a taxpayer has a full-time job, with a salary of $65,000, and $7,400 in federal income taxes withheld. She also has a side business in which she expects to earn a net profit of $22,000. She has made quarterly estimated payments of $800, for a total of $3,200. She has one personal exemption and claims the standard deduction.
The taxpayer expects her federal income tax liability to be $14,500, and her self-employment tax to be $3,109 ($22,000 x 92.35% x 15.3%), for a combined federal tax liability of $17,609. Withholding of $7,400 and estimated payments of $3,200 will reduce her liability to a balance due of $7,009 ($17,609 - $7,400 - $3,200). If she does nothing, she will face an underpayment penalty of $140 because her pro-rata payments and withholding are less than her liability.
If the taxpayer performed this calculation in late December, she would have no time to increase her withholding to cover the shortfall.* However, she may make a large payment using the EFTPS to avoid the penalty.
If she performed this calculation in September or October, she would have time to complete a new Form W-4 to increase her withholding enough to avoid the penalty.
With our pay-as-you-go tax system, it’s important for tax pros and taxpayers to examine taxpayers' projected tax liabilities, payments, and other factors to try to spread their payments throughout the year as much as possible. Doing so will avoid big financial hits – and underpayment penalties.
*The taxpayer doesn’t have to pay the full expected balance due before year-end. However, the taxpayer should pay the minimum to avoid an underpayment penalty.