How does the story of Goldilocks and the Three Bears apply to paying your taxes? Getting it “just right” can help you avoid the IRS underpayment penalty, and potentially make or save you hundreds or even thousands of dollars.

The recent rise in interest rates has made it more important than ever to understand the rules around how much you are required to pay in taxes over the course of the year through income tax withholding or quarterly estimated tax payments.

  • If you underpay, you will incur underpayment penalties assessed by the Internal Revenue Service at a current rate of 8%.
  • If you pay in more than what is required, you may be missing out on interest income now approaching 5% on cash that you hold in interest-bearing accounts.

While the IRS charges you for underpayments, they do not compensate you for overpaying your taxes. So what is the “just right” amount to pay to avoid the IRS underpayment penalty and maximize the amount of interest income? The amount is the lesser of:

  1. 90% of your expected current year income tax liability -or-
  2. 100% of your actual prior year tax liability if your prior year adjusted gross income (AGI) is $150,000 or less. If your AGI exceeds $150,000, it increases to 110% of your actual prior year tax liability.

Most states have the same or similar rules in place regarding charging for underpayment of state income tax and how to calculate the required amounts to pay to avoid the penalties.

Here are some common situations and how to optimize application of the rules.

You expect your income to increase substantially in 2024 as compared to 2023: Option 2 above will result in the lesser required payment. By paying in the lesser amount, you can hold your cash and pay any additional taxes due by April 15, 2025, without incurring any penalty or interest.

You expect your income to be substantially lower in 2024 as compared to 2023: Option 1 will result in the lesser required payment. By completing an income tax projection, you can make payments to reach 90% of your expected income tax for 2024. You will then avoid overpaying by paying in taxes equal to 100%/110% of your 2023 income tax liability.

Your CCM tax team will work with you to apply these calculations and help you avoid unexpected tax penalties. Remember that if your financial situation changes during the year, it’s important to proactively communicate with your advisor to ensure your projection remains accurate.

NOTE: The information provided in this article is intended for clients of Carlson Capital Management. We recommend that individuals consult with a professional adviser familiar with their particular situation for advice concerning specific investment, accounting, tax, and legal matters before taking any action.