Oops! I Did Not Withhold Enough for Taxes. Now What?
As of Jan. 28, 2019, the IRS has started to accept 2018 tax returns. Most taxpayers are watching for their W-2s, 1099s, and other tax related documents to arrive in the mail and are starting to wonder what the new tax law changes will mean when their return is all said and done.
One item of particular interest this year is the amount of withholding, or estimated payments made, throughout the year. Typically, individuals are required to pay a minimum amount (called a “safe-harbor” amount), or are subject to the “underpayment penalty” on their taxes.
Safe-harbor amount? Underpayment penalty? What do these terms mean?
Every year when you file your taxes, there is a calculation to ensure you paid in the minimum amount throughout the tax year. This is called the “safe-harbor” amount. The “safe-harbor” is the smaller of:
- 90% of the total tax liability shown on your current tax return (the return you are about to file), or
- 100% of last year’s total tax liability (for higher income people this is 110% of last year’s total tax liability).
Let’s review an example. If the total tax liability on your 2018 tax return shows $20,000 and your 2017 tax return showed a $25,000 tax liability, then you would have had to pay in 90% of the 2018 taxes ($18,000) or 100% of the 2017 taxes ($25,000). Since $18,000 is the smaller amount, that is the minimum that must have been withheld, or paid in, throughout the year. This liability can be met through withholding (from your wages, pension income, IRA withdrawals, or Social Security income), or from quarterly estimated payments made throughout the year.
If you did not pay at least $18,000 through withholdings and/or estimated payments, you would see an “underpayment penalty” on your 2018 tax return, which would either reduce your refund or increase the amount due.
The IRS recognizes that the Tax Cuts & Jobs Act had several impactful changes, and not all taxpayers were able to accurately figure their tax liabilities under the new law. To accommodate these taxpayers, the IRS released a notice on Jan. 16, 2019, reducing the “safe-harbor” amount from 90% to only 85% for 2018 returns. Using the example above, that means you only needed to pay in $17,000 (instead of $18,000) in order to avoid the “underpayment penalty.” Furthermore, for 2018 only, taxpayers would be eligible for this relief if they paid the 85% threshold by Jan. 15, 2019 (rather than making equal installments throughout the year).
To take advantage of this reduced safe-harbor amount, file Form 2210 with your tax return and request a waiver by checking Part II, Box A and writing “85% Waiver relief” next to Box A.
One caveat: If you miss the 85% mark, even by $1, then the underpayment penalty will be calculated normally (using the 90% threshold), and the penalty itself will not be reduced.
Conclusion: If your 2018 tax return has a tax penalty, consider whether or not the 85% rule applies to you. Be sure to ask your tax preparer if they have done this calculation to ensure you are not unnecessarily subjected to the underpayment penalty. Consult with your financial advisor and tax preparer to help you properly and accurately report this one-time benefit.