fbpx

Blog

Safe Harbor Tax Payments to Avoid Penalties

John J. FureyNovember 1, 2016

Taxes

A client recently asked what is a safe harbor payment for taxes and why should I care about meeting this payment?

Income tax laws (federal and state) are pay-as-you-go systems

The federal and state income tax laws are based on the concept of pay as you go. This means that a taxpayer is obligated to pay taxes on a current basis based on the income being received throughout the calendar year. The three most common ways that you receive income and pay taxes are generally as follows:

  1. If almost all of your income is from employment, your obligation to pay on a current basis is likely met through payroll withholding of income taxes.
  2. If almost all of your income consists of distributions from retirement accounts (such as social security, pension, 401(k) and IRA), your obligation can be met by electing to have income taxes withheld from these distributions.
  3. If a substantial amount of your income is from self-employment or from other income (such as interest, dividends, rents, royalties and pass-through income), you will most likely have to pay quarterly installments to meet your current obligation. Quarterly estimated payments are due on April 15, June 15, September 15 and January 15.

Safe harbor payments to avoid the penalty for underpayment of taxes

The safe harbor payment to the IRS for 2016 is the smaller of 110% of your actual tax liability for 2015 or 90% of your actual tax liability for 2016. If your Adjusted Gross Income in 2015 was less than $150,000, you only have to pay 100% instead of 110%.

The safe harbor payment to the Pennsylvania Department of Revenue is the smaller of 100% of your actual tax liability for 2015 (provided you lived in PA for the full year) or 90% of your actual tax liability for 2016. Many states have similar safe harbor payment rules.

Penalty for underpayment of estimated taxes

If your amounts withheld and any estimated payments don’t meet the safe harbor payment, you will owe a penalty. The penalty is calculated based on the difference between 90% of your actual 2016 tax liability and what you actually paid in taxes during 2016. For example, if 90% of your federal tax liability is $50,000 in 2016 and your payments are $30,000, the difference of $20,000 will be used to calculate the underpayment penalty.

The federal underpayment penalty is calculated based on the assumption that you should have paid the $20,000 in four quarterly installments of $5,000 each. An interest rate is then applied to the cumulative amount not paid and the number of days the payment is late. If you pay the $20,000 in your 4th quarterly payment on January 15, 2017, you will still owe some of the penalty because $15,000 should have been paid during the first 3 quarters. The interest rate is the applicable federal short-term interest rate plus 3 percentage points. That interest rate is currently 4%, but it can change based on market interest rates. The underpayment penalty in Pennsylvania is calculated similarly.

Strategies to meet the safe harbor payment

If you have not made the required quarterly estimated tax payments in 2016, there are three strategies to make payments late in 2016 that can still meet the safe harbor. One strategy is to increase your payroll withholding to make up the deficit in the payment. A second strategy is to increase your withholding if you receive monthly IRA distributions. If you have not yet taken any Required Minimum Distribution from your IRA for 2016, you can request to have a sufficient amount withheld from this distribution to meet the safe harbor. These types of withholdings are considered ratably paid throughout 2016, even though a higher amount was withheld toward the end of the year.

If you have any questions about required safe harbor tax payments or other tax payments, please do not hesitate to contact our office (610-651-2777)

 

Sources

I.R.C. Section 3405, Special rules for pensions, annuities and certain other deferred income

I.R.C. Section 6654, Failure by individual to pay estimated income tax

IRS Publication 505, Tax Withholding and Estimated Tax

Safe harbor for Pennsylvania personal income taxes