How to Avoid Underpaying Estimated Taxes

Hit with an underpayment penalty or trying to continue avoiding one? These fees come from the IRS when you haven’t properly estimated how much tax you were going to owe to the IRS for a particular tax year. Those that do not have taxes withheld by their employer or if you’re withholding does not cover all of your income (such as self employment income), you are susceptible to the penalty. The following tips will help you avoid underpaying estimated taxes.

How to Avoid Underpaying Estimated Taxes

How does it happen?

After you subtract the amount withheld or that you paid in taxes and you calculate the amount you owe, the IRS may assess that you haven’t paid enough and consider it an underpayment. Grounds for penalty is a result of a few calculations. The lesser of a) 90% of the amount of tax you will pay in the year or b) 100% of the amount of tax you paid the previous year. Use this number for the following: if the amount of withholdings and estimated taxes paid is $1,000 less than the smaller of A or B, or more, you will be hit with an underpayment penalty.

What are the exceptions?

Luckily there are several exceptions to either reduce or eliminate the fee. If you are a farmer or fisherman, the amount you pay will depend on different numbers. Instead of the 90%, you will use 66 2.3% of the tax you’ll pay. Maybe you’re not a farmer or fisherman, but you might have an average to higher income. In this case, if your income is greater than $150,000 as an individual, or more than $75,000 and you are Married Filing Separately, replace the 100% figure with 110%. Further, if you didn’t have tax liability the year prior and if you were a resident or legal alien, the penalty does not apply. The same goes if your total withholding and estimated quarterly payments were at least as much as your prior year tax. In these instances, you will have to File Form 2210 – more on that below.

How much will I have to pay?

If this is your first time in the underpayment boat, you’re in luck – the IRS will waive the fee. If it’s your second (or third…), you will most likely have to pay the penalty. There is a chance to reduce or eliminate the penalty, however, by filing Form 2210. This is an opportunity for those who have made adequate and timely payments every quarter. Or if a large portion of your income was made at the end of the year and you had no way of estimating, a large part of your tax payments were made earlier in the year, your filing status change from or to married filing jointly, a casualty or disaster occured, or you are disabled or retired and you have reason to have forgone payment other than neglect.

How to best calculate estimated tax?

When it comes to estimating your taxes to avoid the penalty, the 1040ES is your best friend. The form is admittedly complicated and requires a fair amount of administrative work. But it will certainly help you avoid underpaying estimated taxes in the long run. You may find that instead of underpaying, you’re overwithholding. In this case, you can make adjustments to your W-4. The next estimated taxes are due on April 18th. So, be sure to consult your tax professional to make a reasonable estimate.