What Is Underwithholding and How Do You Fix It?

Underwithholding occurs when the income tax paid to the government throughout the year is less than your total tax obligation. This shortfall means you have not paid enough tax as you earned your income, which can lead to a tax bill when you file your annual return.

Triggers for Insufficient Withholding

A common reason for underwithholding is earning income that is not subject to automatic tax withholding. This applies to freelancers, gig economy workers, and self-employed individuals. Unlike traditional employees, taxes are not taken out of their payments, requiring them to proactively set aside money for their tax obligations.

Significant non-wage income can also lead to insufficient withholding. If you receive substantial amounts from selling investments, stock dividends, or rental properties, this income does not have taxes withheld automatically. A large capital gain, for instance, can dramatically increase your total tax liability, and you will likely be underwithheld if you do not make a corresponding tax payment.

Certain life events can alter your tax situation and trigger underwithholding. For example, if a child ages out of eligibility for the Child Tax Credit, your total tax bill will increase. A change in filing status, such as from married filing jointly to single after a divorce, results in a higher tax rate and a lower standard deduction, which can cause withholding to be inadequate if not updated.

The Underpayment of Estimated Tax Penalty

The U.S. tax system operates on a pay-as-you-go basis, meaning you are required to pay tax on income as you receive it. If you fail to meet this requirement and owe $1,000 or more at tax time, the Internal Revenue Service (IRS) may charge an underpayment penalty. This penalty is an interest charge on the amount of tax that was paid late.

The penalty is calculated based on the underpayment amount, how long it was unpaid, and the quarterly interest rate set by the IRS. For individuals, this rate is the federal short-term rate plus three percentage points. The penalty is assessed for each quarter the tax was underpaid, so you could owe a penalty for one quarter even if you catch up on payments later in the year.

The IRS uses Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, to determine if a penalty is owed. While you can complete this form yourself, you are not required to do so. If you have underpaid and do not file Form 2210, the IRS will calculate the penalty for you and send a notice detailing the amount you owe.

Correcting Your Withholding and Making Payments

To prevent underwithholding from a job, adjust the tax your employer takes from your paycheck by submitting a new Form W-4. Before filling out the form, gather information about your complete financial picture, including other jobs held by you or your spouse and other income sources. You should also have estimates for any tax deductions or credits you plan to claim.

With this information, you can use the IRS’s online Tax Withholding Estimator to determine the most accurate entries for the form. The form allows you to account for multiple jobs, claim dependents, and specify any extra tax you want withheld. Once complete, submit the new Form W-4 to your employer’s payroll department to adjust your withholding.

If you have income not subject to withholding, the method for paying tax is through estimated tax payments. You must first calculate the required payment using the worksheet with Form 1040-ES, Estimated Tax for Individuals. This involves projecting your total expected income, deductions, and credits for the year.

Payments can be made through IRS Direct Pay, the IRS2Go mobile app, or by mail. To avoid penalties, these payments must be made on time in four quarterly installments. The deadlines are:

• April 15
• June 15
• September 15
• January 15 (of the following year)

Utilizing Safe Harbor Rules to Avoid Penalties

You can often avoid the underpayment penalty by meeting one of the IRS’s safe harbor rules. These rules provide clear thresholds for tax payments made throughout the year. Meeting one of these standards protects you from a penalty, even if you owe money with your return.

The first safe harbor rule is based on your current year’s tax liability. If your total withholding and timely estimated tax payments equal at least 90% of the tax you owe for the current year, you will not be subject to the underpayment penalty. This method requires an accurate estimate of your income and deductions for the year.

A second safe harbor rule is based on your previous year’s tax. If you pay at least 100% of the total tax shown on your prior year’s return, you are protected from the penalty. For higher-income taxpayers—those with an adjusted gross income (AGI) over $150,000 ($75,000 if married filing separately) in the previous year—this threshold increases to 110% of the prior year’s tax.