How To Avoid IRS Interest & Penalties
Safe Harbor Rules
Written by: Nicole Gobel, CPA – Wealth Advisor & Tax Planner
Nobody likes paying income taxes. Unfortunately, it is a necessity and important to remember that if you’re paying taxes it means at some point you had income or gains that generated those taxes. But there is no reason to pay penalties or interest unnecessarily. There are certain guidelines that you can use to avoid this.
In this article we will discuss:
- Safe Harbor Rules
- How to Choose Which Apply to Your Situation
- What if I Didn’t Pay Enough?
Safe Harbor Rules
The term “safe harbor” can be used in many areas of the law but in tax law, it refers to being protected from paying penalties when you have fulfilled certain requirements. The IRS understands that tax situations can change from year to year so they provide a few different ways that you can protect yourself from owing penalties in addition to any balance due upon filing.
In general, the key is paying enough taxes through withholding and/or estimated tax payments to cover at least one of the following:
- 90% of your total taxes for the current year
- 100% of your total taxes for the previous year, 110% for those whose Adjusted Gross Income(AGI) was above $150,000 in the previous tax year($75,000 for Married Filing Separately)
- Owing less than $1,000 total after withholdings and credits
These are the Federal guidelines. Each state has their own safe-harbor rules so it’s best to work with your financial advisor and CPA to determine the rules that apply to you.
Which Option is Best for Your Situation?
The amounts for safe-harbor payments can vary significantly depending on your tax situation. It is important to consider your personal circumstances and what would be most advantageous. Ideally, you should aim to pay the least amount possible to protect yourself from penalties while not paying anything extra.
If you are still working and have seen a significant increase in income through your salary or bonus, check to make sure your current year withholding will annualize to at least 100% of last year’s total taxes or 110% if you were over $150k AGI last year. As your income increases, your withholdings should increase as well. However, when individuals have stock awards that vest or significant bonus income, the withholding rates are sometimes too low to cover the taxes due so you may still have a big tax bill upon filing. If you have at least met the safe harbor rules, you will have avoided any unnecessary penalties even if there is a balance due.
Here is an example:
Bill and Sandra are both still working. Last year their AGI was $80,000 and their taxes were $6,190 after taking the standard deduction.
This year both Sandra and Bill received raises totaling $8,000, Bill received an additional $10,000 bonus and Sandra sold some stock for an additional gain of $5,000. Therefore, they expect their total AGI this year to be about $103,000.
As last year’s AGI was under $150,000, they just need to make sure to pay in at least 100% of last year’s taxes to protect themselves from penalties. Their withholdings should have naturally increased with their raises and some tax would also be withheld on Bill’s bonus. However, typically there is no withholding on a stock sale so they would expect to owe taxes on the $5,000 capital gain upon filing.
This year based on the projected AGI of $103,000, less the standard deduction, their total taxes would be $8,841. However, as long as they pay in at least $6,190 based on the previous year taxes they are safe-harbored and can pay the remainder upon filing without penalty.
This example has a significant increase in income and illustrates that it often makes sense for those in this situation to pay in based on last year’s taxes vs. current year projected taxes.
If the reverse is true and your taxable income has decreased, possibly due to a transition to retirement, then it doesn’t make sense to aim for paying in based on last year’s taxes. Instead, you should work with your tax professional to determine what your current year tax liability is projected to be. By paying in at least 90% of the current year taxes you will avoid penalties, however, often clients choose to aim for 100% since you’re still basing the payments on a projection, and it gives an extra 10% buffer for any unexpected income or gains.
Here is an example:
Emily and John have just retired. Their AGI last year was $80,000 and total taxes $6,190.
Emily has a pension of $30,000 and they have decided to wait to elect Social Security benefits until later to allow the amount to grow. John is also beginning to take distributions from his IRA of $30,000 to support their cash flow needs.
Their income has decreased dramatically from last year. In this situation projected taxes on $60,000 of AGI, after taking the standard deduction would be $3,681. As long as they pay in 90% of this amount, or approximately $3,313, they will be protected from underpayment penalties. If they want to be more cautious, they can always aim for 100% of the $3,681 mark since this is still a projected number. Either way, this saves them from paying at least $2,500 to the IRS unnecessarily only to have it returned to them in a refund in upon filing.
It's important to use these guidelines to avoid penalties. An example where someone could pay extra unnecessarily could be the following:
Joe and Jill have a total tax bill of $10,000. Only $5,000 was paid through wage withholding as the income was from sources such as capital gains and retirement distributions that did not include withholding. Joe and Jill’s taxes last year were similar to this year.
If Joe and Jill do not pay their $5,000 balance in advance through estimated payments, they would owe another $130 in penalties plus interest on that amount for each partial month that it is owed. The calculation begins with 0.5% of the balance due each month and is capped at 25% of the amount due but the interest will keep growing until the balance is paid. The IRS announced the interest rate for the fourth quarter of 2022 at 6%; this adjusts quarterly.
What If I Did Not Make Payments Early Enough In the Year?
Ideally, you want to plan early enough in the year to ensure you are paying in equally throughout the year. The challenge is when income is not spread equally. The IRS will assume that any income is earned equally throughout the year and that any tax withholding from wages or retirement distributions is also paid in equally. However, if you must make estimated tax payments to make up for any shortfall, the IRS expects you to pay in 25% by April 15th, 50% by June 15th, 75% by September 15th and the full amount for safe harbor purposes by January 15th of the following year. This allows you to review your income earned during each quarter to pay in accordingly if it is not earned equally.
If you are using the “pay as you go” method because your income is varied through the year you would review what your earnings are for each period ending March 31st, May 31st, August 31st and December 31st. Estimated tax payments for the income related to each quarter would be due at the payment dates noted earlier. However, the IRS will not know when you earned the income, so it is important to have your tax professional complete Form 2210 in order to explain that you paid in the appropriate amounts within the quarter the income was earned.
Another option to make up for taxes owed would be to increase withholding later in the year. Since it is considered to be paid equally it doesn’t matter if you’re paying in a significant amount toward the end of the year. This could apply to wage income or if you are withholding taxes from your IRA distributions. You can take an IRA distribution and have the full amount go to tax withholding, if necessary, however, keep in mind this would increase your taxable income for the current year.
As a last resort, there is also an option to request a penalty waiver. In part of Form 2210 (noted above), your tax professional can explain to the IRS why you were unable to make the payment. There is an exception if you have just retired and are over 62 to request a penalty waiver. If there is a reasonable cause for not making the payment and it was not due to willful neglect, the penalty will be expunged.
In conclusion, it is important to be aware of the following points:
1. The key to safe harbor is paying enough taxes through withholding and/or estimated tax payments to avoid penalties.
2. Determine what safe-harbor rules apply to your situation since safe harbor amounts can vary significantly to allow you to pay in the least amount possible.
3. Start planning early enough to ensure you are paying in equally throughout the year.
4. Work with your financial advisor and tax preparer for guidance around significant changes in your tax situation.
It is important to make sure you are working with a tax professional or CPA that can assist you not only with tax preparation but also tax planning when there are significant changes to your tax situation. If you have any questions regarding how we work with our clients in these areas, please feel free to contact our team.
Bouchey Financial Group has local offices in Saratoga Springs and Troy, NY.