Our “pay-as-you-go” tax system requires that you make payments of your tax liability evenly throughout the year. If you don’t, it’s possible that you owe an underpayment penalty. Some taxpayers meet the “pay-as-you-go” requirements by making quarterly estimated payments. Typically this is how self-employed individuals and those with other non-tax-withheld sources of income satisfy their prepayment obligation. When your income is primarily from wages, however, you meet the requirements through wage withholding and likely rely on your employer’s payroll department to take out the right amount of tax, assuming that you have given them accurate Form W-4 data and that this information has not changed through marital changes, a second job, or your spouse working. Unfortunately, what payroll withholds may not be enough!
You may also be underpaid if you:
Have a gain from the sale of property, e.g., stocks, bonds, or real estate;
Have other income from which there is no withholding (for example, a pension, alimony, IRA, interest, or dividends);
Are subject to the new surtax on net investment income for higher-income taxpayers; and/or
Are married or self-employed and subject to the new additional Medicare (hospital insurance) taxes.
To avoid underpayment penalties, you generally must prepay more than 90% of your current year tax liability or 100% of your prior year tax liability. For taxpayers with incomes in excess of $150,000 in the prior year, pre-paying either 90% of the current year tax liability or 110% of the prior year tax liability will generally avoid underpayment penalties. In addition, the penalties are quarterly-based, so the withholding and estimated taxes need to be paid evenly throughout the year. Please note that state prepayment rules may be different from the federal rules explained in this article. Even though it is late in the year, withholding is treated as paid evenly throughout the year, so you may still have time to adjust your withholding to make up for underpayments in prior quarters. In addition, underpayments are based on when the income was received during the year, and late-year increased estimated tax payments can help offset underpayment penalties for income received later in the year.