The new tax system
Many taxpayers’ paychecks increased in February 2018 after the IRS issued updated withholding tables. The tables dictate the amount of withholding employers must deduct from an employee’s paycheck. The revised tables reflected the new increase in the standard deduction and changes in tax rates and brackets.
When it released the new tables, the IRS cautioned that some taxpayers could find themselves hit with larger income tax bills for 2018 because the new law also reduced or eliminated many popular tax deductions. The tables did not account for the reduced availability of itemized deductions (or the suspension of personal exemptions).
When hired, employees fill out a Form W-4 to calculate the correct number of exemptions so that the employer can use the withholding tables to determine the correct withholding. If an employee did not update their Form W-4 after the tax law changed, the number of exemptions may be too high based on the loss of itemized deductions or similar changes.
The higher standard deduction and expansion of family tax credits may offset the loss of some deductions and the personal exemptions. Indeed, the IRS predicts that most 2018 tax filers will receive refunds.
However, many taxpayers could not predict with certainty how the numerous law changes would impact them. Especially because key guidance on how to apply the law was still being issued late into 2018, with final rules not released until January of 2019.
The Government Accountability Office last year estimated that almost 30 million taxpayers will owe money when they file their 2018 personal income tax returns because of this “under-withholding.” Those particularly at risk include taxpayers who itemized in the past but are now taking the standard deduction, two-wage-earner households, employees with non-wage sources of income and taxpayers with complex tax situations.
The tax code imposes a penalty (known as a Section 6654 penalty) if taxpayers do not pay enough in taxes during the year. The penalty generally does not apply if a person’s tax payments were:
- At least 90% of the tax liability for the year; or
- At least 100% of the prior year’s tax liability. The 100% threshold rises to 110% if a taxpayer’s adjusted gross income is more than $150,000, or $75,000 if married and filing a separate return.
Taxpayers generally can also avoid the underpayment penalty if they owe less than $1,000 in additional tax after subtracting their withholding and refundable credits.
Relaxing the 90% rule to 85%
In response to the potential for widespread under-withholding, the IRS will not pursue penalties for taxpayers who paid at least 85% of their total 2018 tax liability. For those who paid less than 85%, the IRS will calculate the penalty as it normally would. The request for a waiver is made by filing Form 2210, “Underpayment of Estimated Tax by Individuals, Estates, and Trusts,” with his or her 2018 federal income tax return.
What to do now
The underpayment penalty waiver is effective only for 2018. The last day to make an on time payment of 2018 estimated taxes was January 15. However, paying the tax sooner than April 15 can reduce the amount of the penalty. In addition, you should review your withholding for 2019 at this time. The expanded safe harbor does not apply for 2019 withholding and estimated taxes.