A frequent question is how much to pre-pay in withholding and estimated taxes to avoid underpayment penalties. The safe harbor payments are as follows:

So, one might think that 100% of the previous year’s tax would provide protection from underpayment penalties in any circumstance. But that is not true, because for high income taxpayers the rules are different.

So, since it is sometimes difficult to predict a client’s AGI early in the year, the only absolute safe harbor for any eventuality is 110% of the taxpayer’s prior year’s tax liability.

Remember, also that the payments must be paid ratably throughout the year. So, increasing estimates in a later quarter cannot make up for underpaid estimates in earlier quarters. One workaround to that issue is to increase withholding later in the year. Withholding, regardless of when paid, is considered paid ratably throughout the year unless it is specified as being paid when it was actually withheld. It can be difficult for an employee to have a significant increase in withholding. On the other hand, where the employee is in management, it may be possible to have the entire payroll allocated to withholding.

That being said, there are times when using the safe harbor method just isn’t practical. For example, if the taxpayer had an unusually high-income year, applying the 100% or 110% rule may result in estimated instalments considerably higher than their actual tax will be. Some taxpayers may not mind making the higher payments, while others either don’t have the funds to do so or do not want to prepay an excess amount. In these cases, the preparer will need to make a projection of the tax and base the estimated tax payments accordingly and advise the taxpayer that they could incur an underpayment penalty.

Last, but not least, the Form 2210 allows taxpayers to avoid underpayment penalties when the income was not received ratably during the year and the quarterly pre-payments are sufficient to cover the income received each quarter.