How to Reduce a Balance Due Next Year & Avoid an IRS Underpayment Penalty
Many taxpayers are surprised to learn that the US Tax System is a pay-as-you-earn system. That means that income tax is reuired to be paid during the year as income is earned. In other words, filing your tax return in April is generally a reconciliation process — not the actual due date for all of that year’s tax!
If too little tax is paid in during the year through paycheck withholding and/or quarterly estimated tax payments, the IRS can assess an underpayment penalty under Internal Revenue Code.
The good news is that the IRS provides several ways to avoid that penalty. These are commonly referred to as the safe harbor rules.
In general, most taxpayers can avoid an underpayment penalty if at least one of the following is true:
Many taxpayers meet one of these rules automatically through normal paycheck withholding. Let’s walk through what each rule looks like in real life.
Safe Harbor #1: You Owe Less Than $1,000 on your tax return
If the balance due on your return is under $1,000, the IRS generally does not assess an underpayment penalty.
Example
Safe Harbor #2: Pay At Least 90% of Your Current-Year Tax
Another way to avoid penalty is to pay at least 90% of the tax owed for the current year. This method works best when income is relatively stable and predictable.
Example
Safe Harbor #3: Pay 100% of Last Year’s Tax
Many taxpayers prefer to use the prior-year safe harbor, because last year’s tax is a known number. Under this rule, if you pay in at least 100% of the total tax shown on your prior-year return, you generally avoid an underpayment penalty.
Example
Safe Harbor #4: Higher-Income Rule (110% of Prior-Year Tax)
For higher-income taxpayers, the prior-year safe harbor increases slightly. If your prior-year adjusted gross income was above $150,000 (for married couples filing jointly), the safe harbor becomes 110% of last year’s tax.
Example
The Pitfalls of Safe Harbor Rules #3 and #4
While the safe harbor rules are designed to protect taxpayers from underpayment penalties, they can sometimes result in significant overpayment—particularly in years where income fluctuates. For example, consider a taxpayer who has a one-time high-income year due to a large stock sale, bringing their total tax to $80,000. In the following year, their income returns to a more typical level, resulting in an actual tax liability of only $30,000. However, to meet the safe harbor under the higher-income rule, they would need to pay in 110% of the prior year’s tax, or $88,000. In this case, if the taxpayer remitted the $88,000, they would avoid penalties but end up overpaying by $58,000! This is effectively giving the Department of Treasury an interest-free loan until the refund is received. This illustrates why safe harbor strategies, while protective, may not always align with optimal cash flow planning when income varies year to year.
Due to the pitfalls of the Safe Harbor, many taxpayers choose to take a more balanced approach rather than strictly adhering to a single safe harbor method. Depending on their cash flow preferences and tolerance for risk, some may opt to pay in less than the full safe harbor amount and accept the possibility of a modest underpayment penalty, rather than significantly overpaying throughout the year. Ultimately, the decision often comes down to weighing the cost of a potential penalty against the benefit of retaining access to cash during the year, allowing each taxpayer to choose the approach that best aligns with their financial priorities.
There is no single “perfect” outcome when filing a tax return. Some taxpayers prefer a refund. Others prefer to break even. And some are comfortable owing a modest amount, and even a small underpayment penalty, in April.
If your income changes significantly during the year — such as receiving bonuses, selling investments, or exercising stock options — a tax projection can help determine whether your withholding should be adjusted.
If too little tax is paid in during the year through paycheck withholding and/or quarterly estimated tax payments, the IRS can assess an underpayment penalty under Internal Revenue Code.
The good news is that the IRS provides several ways to avoid that penalty. These are commonly referred to as the safe harbor rules.
In general, most taxpayers can avoid an underpayment penalty if at least one of the following is true:
- They owe less than $1,000 when they file, after subtracting withholding and refundable credits
- They paid in at least 90% of their current-year total tax
- They paid in at least 100% of their prior-year total tax
- If their prior-year AGI was above a certain IRS threshold, they paid in at least 110% of their prior-year total tax instead.
Many taxpayers meet one of these rules automatically through normal paycheck withholding. Let’s walk through what each rule looks like in real life.
Safe Harbor #1: You Owe Less Than $1,000 on your tax return
If the balance due on your return is under $1,000, the IRS generally does not assess an underpayment penalty.
Example
- Assume a married couple earned $210,000 during the year.
- Their final federal tax liability ends up being $32,000.
- Throughout the year their employer withheld $31,300 from their paychecks.
- When they file their tax return, they owe $700.
- Even though they owe money, the balance due is less than $1,000, so no underpayment penalty applies.
Safe Harbor #2: Pay At Least 90% of Your Current-Year Tax
Another way to avoid penalty is to pay at least 90% of the tax owed for the current year. This method works best when income is relatively stable and predictable.
Example
- Assume a couple earns $195,000 during the year.
- Their final federal tax liability ends up being $30,000.
- To meet this safe harbor, they would need to pay in at least $27,000 during the year (90% of the total tax).
- If their paycheck withholding totaled $27,500, they would satisfy the safe harbor.
- When they file their return, they would still owe $2,500, but no underpayment penalty would apply.
- This is a common scenario for many wage earners.
Safe Harbor #3: Pay 100% of Last Year’s Tax
Many taxpayers prefer to use the prior-year safe harbor, because last year’s tax is a known number. Under this rule, if you pay in at least 100% of the total tax shown on your prior-year return, you generally avoid an underpayment penalty.
Example
- Assume your 2025 return showed total federal tax of $22,000.
- During 2026, your paycheck withholding totals $22,000.
- But suppose your income increased during the year and your actual 2026 tax ends up being $26,000.
- When you file the return, you would owe $4,000.
- Even though the balance due is larger, you still avoided an underpayment penalty, because you paid in 100% of last year’s tax.
Safe Harbor #4: Higher-Income Rule (110% of Prior-Year Tax)
For higher-income taxpayers, the prior-year safe harbor increases slightly. If your prior-year adjusted gross income was above $150,000 (for married couples filing jointly), the safe harbor becomes 110% of last year’s tax.
Example
- Assume a couple earned $310,000 in the prior year.
- Their total tax on that return was $40,000.
- Because their income exceeded the IRS threshold, their safe harbor target becomes 110% of that amount, or $44,000.
- If their withholding during the next year totals $44,000, they will generally avoid an underpayment penalty — even if their final tax ends up being $48,000 and they owe $4,000 when filing.
The Pitfalls of Safe Harbor Rules #3 and #4
While the safe harbor rules are designed to protect taxpayers from underpayment penalties, they can sometimes result in significant overpayment—particularly in years where income fluctuates. For example, consider a taxpayer who has a one-time high-income year due to a large stock sale, bringing their total tax to $80,000. In the following year, their income returns to a more typical level, resulting in an actual tax liability of only $30,000. However, to meet the safe harbor under the higher-income rule, they would need to pay in 110% of the prior year’s tax, or $88,000. In this case, if the taxpayer remitted the $88,000, they would avoid penalties but end up overpaying by $58,000! This is effectively giving the Department of Treasury an interest-free loan until the refund is received. This illustrates why safe harbor strategies, while protective, may not always align with optimal cash flow planning when income varies year to year.
Due to the pitfalls of the Safe Harbor, many taxpayers choose to take a more balanced approach rather than strictly adhering to a single safe harbor method. Depending on their cash flow preferences and tolerance for risk, some may opt to pay in less than the full safe harbor amount and accept the possibility of a modest underpayment penalty, rather than significantly overpaying throughout the year. Ultimately, the decision often comes down to weighing the cost of a potential penalty against the benefit of retaining access to cash during the year, allowing each taxpayer to choose the approach that best aligns with their financial priorities.
There is no single “perfect” outcome when filing a tax return. Some taxpayers prefer a refund. Others prefer to break even. And some are comfortable owing a modest amount, and even a small underpayment penalty, in April.
If your income changes significantly during the year — such as receiving bonuses, selling investments, or exercising stock options — a tax projection can help determine whether your withholding should be adjusted.
How W-2 Wage Earners Can Adjust Their Withholding
The Form W-4 is imprecise and generally requires annual tweaking. If you are a W-2 employee, the easiest way to reduce or eliminate a balance due next year is usually to increase your paycheck withholding. For many taxpayers, this only requires some tweaking if done early in the calendar year.
One thing to keep in mind is that Form W-4 is designed to estimate withholding for the entire calendar year. If you update your Form W-4 later in the year — which is common if you are reading this article during tax season or later in the year if your return was on extension — the form does not automatically account for the months that have already passed. For that reason, the most effective approach is often to request additional withholding per paycheck.
The Form W-4 is imprecise and generally requires annual tweaking. If you are a W-2 employee, the easiest way to reduce or eliminate a balance due next year is usually to increase your paycheck withholding. For many taxpayers, this only requires some tweaking if done early in the calendar year.
One thing to keep in mind is that Form W-4 is designed to estimate withholding for the entire calendar year. If you update your Form W-4 later in the year — which is common if you are reading this article during tax season or later in the year if your return was on extension — the form does not automatically account for the months that have already passed. For that reason, the most effective approach is often to request additional withholding per paycheck.
A simple way to estimate the adjustment
A practical approach is to use the balance due from the tax return that was just delivered to you.
Example:
Where to enter this on the Form W-4
If you are married
If both spouses work, the extra withholding does not need to come from a specific paycheck.
For example, you could:
The IRS simply looks at the total withholding paid during the year, regardless of which employer (or spouse, if you are married) withheld it.
This approach works best when your income and deductions are relatively similar from year to year. If your income increases significantly — for example through bonuses, investment gains, or stock compensation — you may want to increase withholding further to stay within one of the safe harbor rules discussed above.
Note: There's no limit to the number of times you can adjust your withholding on the Form W-4! You could request an adjustment every pay-period, if desired.
A practical approach is to use the balance due from the tax return that was just delivered to you.
Example:
- Say your tax return shows that you owe $4,000. If you want to minimize a similar balance next year, you could spread that amount across the remaining pay periods in the current year.
- If you are paid monthly and there are 9 months left in the year, you could request approximately $445 of additional withholding per paycheck.
- If you are paid every two weeks and have 19 pay periods remaining, the adjustment would be about $210 per paycheck.
- This gradual increase often closes the gap over the course of the year.
Where to enter this on the Form W-4
- Extra withholding is entered on Form W-4, line 4(c) — “Extra withholding.”
- Many employers also allow you to update withholding through an internal payroll portal, where the field may simply be labeled “additional tax withholding” or something similar.
If you are married
If both spouses work, the extra withholding does not need to come from a specific paycheck.
For example, you could:
- Split the increase between both spouses
- Have one spouse withhold the entire adjustment
- Adjust whichever paycheck is easiest to modify
The IRS simply looks at the total withholding paid during the year, regardless of which employer (or spouse, if you are married) withheld it.
This approach works best when your income and deductions are relatively similar from year to year. If your income increases significantly — for example through bonuses, investment gains, or stock compensation — you may want to increase withholding further to stay within one of the safe harbor rules discussed above.
Note: There's no limit to the number of times you can adjust your withholding on the Form W-4! You could request an adjustment every pay-period, if desired.
