Understanding underpayment penalty: implications and how to avoid it in the future

Question

Here is a small explanation of my situation which I hope will help to understand my question:

I am a full time employee who lives in California. Each year I get a W2 from my employee and 1099 from my brokerage account. All the years before 2020 I got Federal and California refund at the end of the tax year.

In the middle of 2020 tax year I changed a job and this was the first year I owed money to government: ~$7k Federal, but got a ~$5k California refund. I filed taxes in time (paying that $7k) so I thought that it is not a big deal and forgot about it thinking that the issue have been due to the job change.

This year it seems like I owe ~$14k to Federal and get ~$3k California refund. On top of this TaxAct tells me that I have ~$200 of underpayment penalty.

I have no problems paying this, but:

1. I feel like I have done some mistake as this is the second year I owe federal taxes. I think I should ask my company to withhold more, but not sure if this is the right approach.
2. Based on my understanding I got an underpayment penalty this year because in previous year I owed federal tax. So seems like in the next year I will get another underpayment penalty. What are the implications of this and how can I avoid it in the future?

I was trying to schedule a visit to IRS to ask more about my situation, but not surprisingly everything is booked now, so I will do this after tax deadline. I would appreciate if anyone can answer my questions.

Answer 1

Option 1 is that you're generating enough capital gains, interest, and dividends from your brokerage account that you want to increase your withholdings to account for that. Option 2 is that the W-4 your employer has on file is incorrect and is causing that employer to under-withhold. In either case, you should be able to fill out an updated W-4 form (most large employers have an online portal where you can fill this out rather than using the PDF from the IRS) that corrects the issue.

You can ensure that you're not paying an underpayment penalty by meeting one of the safe harbors. For most people, the easiest approach is to ensure that you're withholding enough this year to cover 100% of the taxes you paid last year (i.e. your total tax bill). You know what you paid in taxes last year and you can see how much is being withheld over the course of the year so you can always add additional withholding if you see that you're getting close to the end of the year and you're in danger of not withholding enough.

Answer 2

Your may have change your withholdings, or your employer may have changed it.

This is the box where you put 0, 1, 2 (you might be able to put higher numbers). Check with your employer and see what level of W-4 withholdings HR has for you.

I owed taxes one year because my company migrated to a hew HR database and hired a bad programmer to do it. The guy screwed up a lot of data, including my withholdings. It was set to 3 instead of 0, which meant I had too little withheld. This is the most likely cause.

Talk to a human in HR and they should be able to resolve this.

Answer 3

There is no reason to updated you w-4 if it is correct. e.g. Correct number of dependents, etc.

From your question, you are doing very well with capital gains. Best bet is to make quarterly estimated payments based on your quarterly capital gains.

The reason not to update your w-4 to withhold additional amts is there is no guarantee next year you will have such capital gains.

https://www.irs.gov/faqs/estimated-tax/large-gains-lump-sum-distributions-etc/large-gains-lump-sum-distributions-etc

Answer 4

In addition to the other answers, you may have significant 'supplemental' income (ie bonuses, commissions, etc). You could be in a situation where you're W4 is correct with correctly estimated 1099 income, but still are faced with an underpayment penalty because of how supplemental income is withheld. Supplemental income is withheld at a 22% federal rate regardless of your tax bracket, which means if you're effective federal income tax is higher than 22%, than you'll owe money regardless of you and your employer's payroll processing company doing everything correctly.

An either case, you'll need to estimate your actual yearly taxes and how much will be withheld and either add an amount for 'extra withholding' on 4c of your W4 or make quarterly estimated taxes and add it to Line 26 of the 1040.

(Side note: this is could also be why you have significant California tax refunds, because CA forces 'supplemental' income classified as bonuses to be withheld at a 10.3% rate regardless of your marginal tax rate, which might be way higher than your effective CA tax rate)

Answer 5

Based on my understanding I got an underpayment penalty this year because in previous year I owed federal tax. So seems like in the next year I will get another underpayment penalty. What are the implications of this and how can I avoid it in the future?

No, this is incorrect. Underpayment means that you didn't pay enough through withholding for the tax year you're filing right now. So if you're filing in April 2022, you're filing for tax year 2021, and that means that throughout 2021 you didn't withhold enough.

The federal government wants everyone to pay their taxes throughout the year through withholding. But without a time machine it's impossible to always pay exactly the right amount, so you just have to guess a bit and then either pay the remaining balance or get a refund at tax time. To encourage people to do a good job at guessing, the IRS gives you a penalty if you didn't guess "good enough".

The part that confuses people is how the IRS decides if you've done a good enough job. Obviously if you get close to what your total for the year turns out to be then your guess was pretty good, so that counts, but the whole problem was that accurately guessing can be difficult. So if you estimate based on your previous tax year's total, that also counts as "good enough".

So for tax year 2021 (filing April 2022), you need to have (in the past), throughout 2021, have withheld enough to either be close to whatever your total 2021 taxes turn out to be OR enough based on 2020's taxes.

For tax year 2022 (filing in April 2023), to avoid an underpayment penalty, you need to withhold (in the current year/future), throughout 2022, based on either accurately guessing what your taxes will be for 2022, or estimating based on what your taxes were for 2021. Obviously estimating based on the past is more reliable than predicting the future, so I recommend that one.