We ask clients to send us their completed tax returns every year. This helps us identify planning opportunities, informs trading decisions, and allows us to be a second set of eyes for penalties, discrepancies, and errors (we tend to find a few each year). A recent federal court decision (Kwong v. the United States) opened the possibility for refunds of interest and penalties that accrued during the federally declared COVID disaster period between January 20, 2020, and July 10, 2023. This court case further illuminated the fact that taxpayers are paying billions of dollars in underpayment penalties each year.
There are a few ways to meet the minimum safe harbor payment requirement, which serves to avoid underpayment penalties for most individuals and trusts. Payments can be based on the current year’s tax liability or the prior year’s total tax (for 2025, 1040 line 24). If you base your payments on the current year, you must pay at least 90% of your total tax. However, this may be difficult to calculate if your taxable income fluctuates. If you base your payments on the prior tax year, the safe harbor amount further depends on the prior year’s adjusted gross income or AGI (for 2025, 1040 line 11). If your AGI was $150,000 or under (single or joint filers), you must pay at least 100% of the prior year’s total tax. If your AGI was over $150,000 (single or joint filers), you must pay at least 110% of the prior year’s total tax. This second method is easier to calculate, but if your taxable income has substantially decreased, you could be letting the government “borrow” your money interest-free until you file your tax return and receive your refund.
It is equally important to be aware that the IRS is a pay-as-you-go system, and your payments should be made throughout the year as you earn income. Even if you meet the total safe harbor payment requirements, you may still be subject to potential underpayment penalties if the timing of payments is off. If you are a W-2 employee, it is beneficial to review your income tax situation as circumstances change, or at least annually, and adjust your per paycheck withholding, if necessary. If you are a 1099 employee with consistent income, you should make equal quarterly tax payments by the April 15th, June 15th, September 15th, and January 15th estimated tax deadlines. It is also beneficial for you to reevaluate your estimated payments as circumstances change, or at least annually. If your 1099 income occurs unevenly throughout the year, such as a lump sum IRA or annuity required minimum distribution, or a year-end Roth conversion, you need to pay enough tax to meet safe harbor and ensure your tax preparer is aware of the uneven timing so they can apply the correct calculation method. Otherwise, the IRS may assume your income occurred evenly throughout the year, opening you up to potential underpayment penalties.
Depending on your unique circumstances, this can be a complex concept. Our goal is for clients to avoid underpayment tax penalties while also not paying significantly more tax than is necessary. We are here to provide the best guidance, alongside your tax preparer, to help clients save the most on their taxes and avoid unnecessary penalties. For our clients, please continue to provide us with your tax returns as they are completed. For prospective clients, we would love to have a conversation if you do not receive this type of comprehensive tax planning.
For more details, you can visit the IRS website at https://www.irs.gov/payments/underpayment-of-estimated-tax-by-individuals-penalty.
This Commentary is provided by Spraker West Wealth Management, a registered investment advisor, and is for informational purposes only. It should not be construed as investment advice and is not intended as a solicitation of any specific product or service. Investments and/or investment strategies include risk including the possible loss of principal. There is no assurance that any investment strategy will achieve its objectives. Information provided is not intended as tax or legal advice and should not be relied upon as such. You are encouraged to seek tax or legal advice from a qualified professional.