The United States tax system is “pay-as-you-go,” which means that taxes are paid as income is earned. For employees or taxpayers taking distributions from retirement accounts, this is handled through withholding. For self-employed workers or taxpayers with large amounts of untaxed income, such as dividends, capital gains, or pass-through income, quarterly estimated tax payments should be made as income is received.
Because the government wants access to tax revenue, taxpayers who underpay their taxes will incur underpayment penalties.
Just because a return shows an underpayment doesn’t automatically mean the taxpayer will be saddled with a penalty. If they have paid in enough to qualify for an underpayment safe harbor, no penalty will be assessed.
For taxpayers with prior-year AGI below $150,000, as long as they have paid in at least the smaller of 100% of the prior year’s tax liability or 90% of the current year’s tax liability, there will be no penalty for underpayment.
Once prior-year AGI exceeds $150,000, the prior-year percentage jumps to 110%.
Taxpayers will also avoid the underpayment penalty if, after subtracting withholding and refundable credits, they owe less than $1,000 with the return.