April is approaching and the dreaded tax season is in full swing.
To make matters worse, if you are diligently investing to achieve financial freedom, you might be in for a rude awakening when Uncle Sam realizes you haven’t paid him enough taxes throughout the year!
If you’re a high-income earner with a sizeable investment portfolio, beware that your tax withholding from your day job might no longer be enough to keep you from underpayment tax penalties.
The fact is, the more assets you accumulate, the higher likelihood you will have to start making additional estimated tax payments throughout the year.
Luckily there is an easy solution to prevent being penalized – the tax safe harbor.
Under the tax safe harbor, regardless of how much income you have this year (from your job, investments, etc.), as long as you pay 110% of the federal taxes you paid last year through a combination of employer withholding and voluntary estimated tax payments, you won’t get penalized during tax season.
On top of saving you from underpayment penalties, the safe harbor rule can also make you more money by using the interest-free loans from Uncle Sam on your tax liabilities.
Instead of looking forward to a tax refund, you should find every opportunity to owe as much taxes in April (without incurring any underpayment fees and penalties), and maximize your interest-free loan throughout the year!
At the end of the day, the tax man will always get his share, so might as well make some money off the taxes you have to pay anyway.
Not understanding the tax safe harbor rule can cause you to miss out on tens or hundreds of thousands of dollars in opportunity costs that could have gone toward living your best life!
The Safe Harbor Rule Is Your Best Friend During Tax Season
For high earners, taxes are your biggest ongoing expense that limits your ability to build wealth.
Not understanding tax rules is shooting yourself in the foot.
For most people working a W2 job, their employers will automatically withhold enough tax to cover their day job incomes. However, if you are aggressively saving, investing, and building your financial freedom, at some point your employer withholding will no longer be enough.
Any time you have significant income outside your day job, you have a higher chance of getting hit with tax underpayment penalties.
The most common reasons are below:
- Significant capital gains / one-time income (e.g. sale of house, sale of business, stock compensation, large commissions, etc.)
- Significant amount of dividends and interest (e.g. stocks, bonds, CDs, etc.)
- Significant amount of unanticipated income that has no taxes withheld (e.g. lawsuit settlement)
With taxes being as complicated and time-consuming as they already are, instead of burning time calculating what 90% of your current tax liability is for the year (i.e. current year tax rule) or owing under $1,000 in taxes when you file (i.e. de minimis tax rule), the 110% safe harbor rule is the easiest, and simplest way to avoid paying any tax penalties.
All you need to remember is to pay at least 110% of your last year’s taxes through withholding and estimated payments (100% if your income is less than $150,000).
If you are still in the growth phase of your career, this can be extremely helpful because it’s a headache to predict what your taxes will be if your income is variable and changing on a year-over-year basis.
As long as you know the amount of federal income tax you paid last year, and add 10% on top of it, you’ll be in the clear from the IRS from any penalties or interest.
However, don’t forget that even if you don’t have to pay all your taxes immediately by using the safe harbor, you still have to pay them eventually when taxes are due! So make sure you plan around having enough cash on hand the following April to pay off your tax liabilities in full.
The safe harbor rule is your best friend when it comes to simplifying your taxes and making you more money off your tax liabilities. Here are a few examples to demonstrate its usefulness.
Example 1: Significant Increases In Income – Big Bonus
Let’s say last year Henry earned $300,000, paying ~$72,000 in federal taxes, and expects to get a large bonus for hitting sales targets over the year that’s paid at the beginning of the next year.
Turns out, he knocked it out of the park and gets a $1 million year-end bonus that hits his bank account in January.
Instead of having to pay ~$325,000 of federal taxes immediately, all he needs to do is make sure he pays 110% of his taxes from last year (i.e. ~$79,200) through his employer’s payroll deductions and estimated payments, and regardless of how much more income he makes throughout the year, he will be safe from any tax under withholding penalties.
The remaining ~$245,800 of taxes that he owes Uncle Sam from the $1 million bonus is not due until the April 15th tax deadline the following year (because Uncle Sam still wants his full share of taxes!)
If he takes this free loan from Uncle Sam and invests this extra cash in short-term Treasuries at ~4%, he could stand to earn ~$10,000 from interest payments by holding on to his tax liabilities until the actual due date.
As you can tell, the larger the dollar amount of the tax liability, the bigger the benefit of holding onto this extra cash instead of paying it upfront.
Source: Smart Asset
Example 2: Significant Capital Gains – House Sale
Let’s look at another scenario. Instead of getting a large bonus, Henry owns a house that has appreciated by $2 million and he plans to sell it at the start of the new year.
Again, as long as he withholds and makes estimated payments equal to 110% of his federal taxes from last year, he won’t have to worry about any tax penalties.
He’ll also get an interest-free loan on the taxes he owes from the sale of the house so he can reinvest the proceeds immediately in other assets (and make more money) while setting aside some taxes in a risk-free short-term treasury bill (earning more money) and planning out his cash flows to fully repay the taxes on the house next April when he goes to file his taxes.
The safe harbor rule gives you financial flexibility with your tax planning and is a great tool to have in the back of your mind any time you want to sell a major asset or investments that have appreciated.
Example 3: Significant Dividends – $10 Million Inheritance
Lastly, let’s assume that Henry receives an inheritance of $10 million in low-cost stock index funds.
Although the $10 million of index funds are tax-free under the estate tax threshold (with the tax basis step up to market value), they pay a ~1.5% dividend yield which amounts to ~$150,000 of additional dividend income during the year that Henry forgets to make tax payments on throughout the year.
Luckily, Henry’s been doing well in his job and got a raise this year at his day job. Because his employer automatically withholds higher income taxes to account for his raise, he paid 10% more in taxes through his paycheck deductions and doesn’t incur any tax penalties from not paying estimated tax payments on his dividend income.
The lesson here is to be careful when you have a lot of investment income through dividends, interest, and capital gains in addition to your w2 income. It’s especially easy to forget to make estimated tax payments on your stock dividends because they might be reinvested automatically and the amount of dividends you receive will change from time to time.
Note, if Henry’s dividend income comes from low-cost stock index funds, then he will receive mostly qualified dividends taxed at favorable LTCG tax rates of 15% – 20% (or 18.8% – 23.8% with the NIIT if he has an income of over $200,000 a year).
The Trajectory Of Your Income Matters
Understanding the trajectory of your income is important when it comes to avoiding any penalties come tax time.
If you’re in the growth phase of your career and your income is on the rise, there’s a good chance that your employer’s automatic withholding will help you avoid tax penalties by withholding enough to meet either 90% of your current year’s federal taxes or 110% of your previous year’s taxes.
However, if your income jumps significantly and you have the option to choose between the two, withholding less taxes upfront by using the 110% tax safe harbor can get you a free loan and reduce the opportunity cost of paying your tax liabilities early.
If at some point your income levels out or drops, then you’ll want to be careful with the amount of taxes your employer withholds and spend some time figuring out what 90% of your current year’s taxes.
At this point, the extra effort spent will be worthwhile so you can withhold the least amount of taxes, reducing lost opportunity costs, while still avoiding tax underpayment penalties.
States Have Their Own Safe Harbors
In addition to penalties on your federal taxes, keep in mind that you can get penalized by your state as well for not withholding enough throughout the year!
The great thing is that most states also have their own tax safe harbor rules, and most are similar to the federal rules with some being more restrictive for high earners and some being more relaxed.
For example, New York state tax safe harbor mostly follows the federal rules.
In New York, as long as you withhold either 90% of your current year’s New York state taxes or 110% of your previous year’s New York state taxes (100% if your New York adjusted gross income is below $150,000) you won’t have to worry about any underpayment tax penalties.
Note, however in New York, the de minimis rule applies only if you expect to owe less than $300 of New York State taxes, unlike $1,000 for federal taxes. But this generally isn’t a concern if you focus on the 110% safe harbor rule for New York state.
On the other hand, California state tax safe harbor is more restrictive for high-income earners.
In California, high earners with adjusted gross income of $1 million or more must pay 90% of their current year’s California state tax to avoid a penalty.
Those making more than $150,000 but under $1 million can still pay at least 110% of their last year’s California state taxes, like the federal rule.
Lastly, New Jersey tax safe harbor is more relaxed for high-income earners.
In New Jersey, for individuals with income over $150,000, as long as you withhold 80% of your current year’s New Jersey State taxes or 100% of your last year’s New Jersey state taxes, you will meet the requirements of the safe harbor.
Changing Your W4 Is the Easiest Way To Meet The Safe Harbor
If you happen to realize that you have not paid enough taxes to Uncle Sam or your state, don’t worry.
First, check if you will satisfy the tax safe harbor rules for your federal and state taxes. If you do, then you are in the clear and can better prepare for next tax season to make the appropriate changes in your withholding and estimated tax payments.
If you are not on track to hit the safe harbors through your employer withholding and haven’t made any estimated tax payments throughout the year, the easiest way to fix that is by changing your W4 form (typically with all your other tax documents in your HR portal) to have additional taxes withheld from your paychecks before you plan to file your taxes.
Increasing your W4 withholding, even if later in the year, will still be considered “on time” when it comes to paying your taxes and can allow you to meet the safe harbor requirements at the end of the year, saving you from underpayment penalties.
Alternatively, you can also choose to make estimated tax payments at the beginning of each tax year to the federal government and your state to make up for any expected shortfall in tax withholding.
The downside to making estimated tax payments is that you typically have to calculate your expected tax liabilities for the year along with how much your employer will withhold (which is time-consuming). Then you have to set everything up before April and make 4 equal payments throughout the year on April 15th, June 15th, September 15th, and January 15th of the following year.
Hence, the easier way is just to adjust your tax withholding through your employer using a W4 form. This way you can make changes to your payments at any time throughout the year, without being bound to making certain payments at certain times.
This will give you maximum flexibility when it comes to planning out your taxes and allow you to take full advantage of delaying your tax payments until the April due date.
Avoid Tax Penalties And Enjoy Your Interest-Free Loan
Throughout the year, remember to review your taxes if you have significant income changes (either up or down) at your day job or have significant amounts of additional income through interest, dividends, and capital gains from your investments during the year.
Make sure you are either paying 90% of your current year’s taxes or 110% of your previous year’s taxes, whichever is lower. Change your employer’s withholding through your W4 form to make up the difference if you can’t meet the safe harbor threshold, or reduce the amount of tax withholding if you already meet the safe harbor for the year.
This way you will easily be able to avoid any tax penalties and benefit from an interest-free loan any time you can withhold less than the full amount of taxes you owe (without paying penalties of course).
Use your interest-free loan on your tax liabilities to make some interest and/or front-load your investing before they are due the following year.
Over the long run, you will enjoy thousands of dollars of additional opportunity cost savings and never pay a dime in additional tax penalties!