Tax Safe Harbor Rules: How to Avoid IRS Underpayment Penalties
One of the more common tax planning questions I receive from clients is whether they need to make an estimated tax payment after realizing a significant amount of income. Maybe they've sold company stock with a large capital gain, completed a substantial Roth conversion, or sold a business they've spent years building. All three can result in a sizable tax bill. But what many people don't realize is that owing a large amount in taxes doesn't necessarily mean you need to pay those taxes immediately.
The IRS has rules, commonly referred to as safe harbor provisions, that can provide considerable flexibility in when those taxes must be paid.
Understanding the 110% Tax Safe Harbor Rule
The IRS operates on a pay-as-you-go tax system. Taxes are generally expected to be paid throughout the year, either through withholding from your paycheck or quarterly estimated tax payments.
If you don't pay enough throughout the year, you may owe an underpayment penalty when you file your return. However, there's an important exception.
For taxpayers whose prior-year adjusted gross income exceeded $150,000 ($75,000 if married filing separately), you can generally avoid federal underpayment penalties by paying 110% of your prior year's total tax liability through timely withholding or estimated tax payments. This is true even if your current year's tax liability is significantly higher.
For those below the income threshold, the requirement is generally just 100% of the prior year's tax liability. Another option is to pay at least 90% of your current year's taxes.
An Example: Selling Stock With a Large Capital Gain
Let's assume your total federal tax liability last year was $40,000, and your adjusted gross income exceeded $150,000.
This year, you sell a concentrated stock position that has appreciated significantly, resulting in a much larger tax bill. Your total federal tax liability for the year is now $180,000.
Under the safe harbor rules, you would generally need to pay just $44,000 throughout the year (110% of last year's $40,000 liability) to avoid underpayment penalties. That leaves $136,000 in federal taxes that can be paid the following April when your tax return is due. And assuming you've satisfied the safe harbor requirements with payments made on time, you won't owe an underpayment penalty on that $136,000. That's a meaningful amount of money that can remain in your possession for several additional months yielding 4-5% of extra interest.
When Safe Harbor Planning Is Particularly Valuable
I find these rules especially useful in three situations.
Selling appreciated stock. For someone who has accumulated company stock over many years, selling a large position can generate a substantial capital gain. Understanding safe harbor requirements can help avoid unnecessarily sending a large estimated payment to the IRS months before it's due.
Roth conversions. Converting money from a traditional IRA to a Roth IRA generally creates taxable income. Depending on the size of the conversion, this can result in tens or even hundreds of thousands of dollars in additional taxes. Those taxes don't necessarily need to be paid at the time of the conversion.
Selling a business. Business owners can experience an enormous jump in income during the year they sell their company. Their current-year tax liability may be many times larger than the previous year's. This is a situation where safe harbor planning can be particularly valuable.
In each case, the taxes are still owed. We're simply determining how much needs to be paid during the year to avoid penalties versus how much can wait until April.
One Important Detail About Tax Withholding
There's another wrinkle that's particularly helpful for retirees.
While quarterly estimated tax payments generally count when they're actually made, federal taxes withheld from IRA distributions are generally treated as though they were paid evenly throughout the year, even if the withholding occurs in December. For example, someone taking a required minimum distribution (RMD) late in the year may be able to increase the amount withheld from that distribution to satisfy their safe harbor requirements. This can be helpful if they haven't made sufficient estimated payments earlier in the year.
What Should You Do With the Money in the Meantime?
Just because the IRS allows you to delay paying taxes doesn't mean the money should be spent or invested aggressively. In fact, I like establishing a dedicated account for taxes whenever someone expects a sizable tax bill. This keeps the money separate from everyday spending and other investments, making it much easier to know exactly what's available to pay the IRS when April arrives. For these dollars, I generally prefer one of two options:
- A dedicated high-yield savings account (HYSA).
- Short-term U.S. Treasury bills, typically with maturities of one to three months. I'm a big fan of SGOV, a short-term 1-3mo. treasury bill ETF.
Both allow you to earn some interest while keeping the money readily accessible and avoiding unnecessary stock market risk. After all, money you've earmarked for taxes isn't money you can afford to lose.
A Final Consideration
Keep in mind that these are federal safe harbor rules. States have their own estimated tax requirements, which may differ from the IRS. And while the prior-year safe harbor is relatively straightforward, the timing of payments matters. Making one large estimated tax payment in December doesn't necessarily eliminate penalties for earlier quarters. For those with income concentrated late in the year, the IRS also provides an annualized income method that may help.
As with most tax planning matters, coordination between your financial advisor and CPA is important.
I believe in paying the taxes you owe, but see little reason to pay them months before you're required to, especially when that money could be earning interest in the meantime.
