As a proponent of owing federal taxes during filing season as opposed to receiving a refund, I have to be wary to avoid penalties for underpaying taxes along the way. Federal taxes are meant to be a 'pay as you earn' system where you should be "safe harbor" tax law, which are the conditions I need to satisfy in order to NOT owe penalties for underpayment. These can be found in chapter 4 of Publication 505 of the IRS website, which I will describe in more detail in this post.
To avoid paying penalties for underpaying taxes, you must satify one of the criteria below:
- Your combined withholdings and estimated tax payments are at least 100% of your prior year tax liability (e.g. if you paid a total of $30k in taxes last year, and you withheld over $30k in taxes this year, then you will not owe a penalty). There are exceptions to this rule, specifically to high income earners, farmers, and fishermen. I will only discuss high income earners further down in this post as that is more relevant to this blog.
- Your combined withholdings and estimated tax payments is at least 90% of your current year tax liability (e.g. if you owe a total of $30k in taxes this year, and you withhold over $27k along the way, then you will not owe a penalty).
- The remaining amount of taxes you owe after subtracting withholdings and estimated tax payments is less than $1,000.
- You had zero tax liability the year before (i.e. if you did not work and had no income, you will not owe any penalties). This may be relevant to those of you who are starting residency and did not pay any taxes the year before. You will owe no penalties even if you overestimate the number of withholdings to select. Refer to my post on filling out the W4 form in the first year of residency.
- You did not withhold any taxes and your total tax liability is less than $1,000.
Exception: for high income earners with an AGI greater than $150k, the percentage limit described in criteria 1 above is slightly higher, and described below:
- Your combined withholdings and estimated tax payments are at least 110% of your prior year tax liability (e.g. if you paid a total of $30k in taxes last year, and you withheld over $33k in taxes, then you will not owe a penalty).
For those of you who are increasing your moonlighting year after year, and subsequently increasing your income, you will want to pay attention to these rules. This is especially important because if you are paid 1099 income, then you will be responsible for paying estimated taxes or withholding extra amounts from your W2 salary to satisfy these rules. Good luck!