The IRS not only wants you to pay what you owe but in many instances, they don’t want you to wait until the end of the year to do so. If your primary income is a salary from an employer, this is pretty simple. Just make sure you get your withholding correct, and you will have withheld enough by the end of the year to cover what you’ll owe. But what if your salary is inconsistent, or there has been a change – retirement, for example? Fortunately, the IRS has established clear rules about how you can avoid an underpayment penalty in these cases as well as a mechanism by which you can pay estimated taxes if you need to do so.

The underpayment penalty can come into play if you owe more than $1,000 at the end of the tax year. However, regardless of how much you owe, you typically will not be subject to an underpayment penalty if you have either:

  • Withheld and/or made estimated tax payments of 90% of the current year’s liability OR
  • Withheld and/or made tax payments equal to 100% of the previous years’ liability (or 110% if your Adjusted Gross Income was above $150k if you filed jointly or $75k if you filed individually).

If you find yourself in the position of being subject to the underpayment penalty, you have a couple of options. They are:

  • Making payments for estimated taxes – estimated payments are made quarterly, and they are due in April, June, September, and January. Bear in mind though that the IRS considers both the amount and timing of payments when it comes to calculating the underpayment penalty. This is why quarterly payments are typically equal in amount – trying to make up for underpayment via estimated payments later in the year can still subject you to an under-withholding penalty for the underpayment that occurred earlier in the year.
  • Changing your withholding – another option to avoid the underpayment penalty is to increase your withholding. One key advantage of taking this route is the IRS treats taxes withheld as if they were withheld evenly throughout the year — they don’t consider the timing of the withholding as they do with estimated tax payments. Thus, you can use this method to correct any underpayment earlier in the year.

So how should you handle your estimated taxes to avoid the underpayment penalty if you have seen a change in income? If you are retiring and your income will substantially decrease, use the 90% rule – that is, pay at least 90% of your liability via estimated payments or withholding, and you won’t be subject to the underpayment penalty (for more on taxes in retirement, see this post).

If you are in a situation where your income will increase, you can use the prior year rules to avoid the underpayment penalty. Depending upon your income, you’ll need to withhold either 100% or 110% of the prior year’s liability. Beyond avoiding the underpayment penalty, we recommend working with an accountant if your income is driven upward due to a significant liquidity event. In these cases, you’ll want to ensure not only that you avoid the underpayment penalty, but also that you set aside enough in cash to cover what you’ll owe.