When it comes to taxes, less isn't always more because If you don't withhold enough from your paycheck, you may end up surprised at how much you owe Uncle Sam at tax time. And the chances that you are under-withholding taxes are higher than you may think.

A 2018 report by the Government Accountability Office (GAO) suggested that a fifth of taxpayers might owe taxes in 2019 due to under-withholding. The concern was particularly significant that year due to changes in the 2017 Tax Cuts and Jobs Act. The updated W-4 form from the Internal Revenue Service (IRS) was fully implemented by 2021, and for some, those changes came as a surprise in the form of a more expensive tax bill.

However, no matter what tax year, it's important to withhold the correct amount from your paycheck to avoid underpaying the government.

Key Takeaways

  • Nearly one out of five taxpayers may have owed taxes in 2019 due to changes made in the Tax Cut and Jobs Act of 2017. 
  • Many people were coping with under-withheld taxes because the U.S. Treasury Department did not update the personal withholding amount to reflect changes in the tax law.
  • Likely candidates for under-withholding included married taxpayers with multiple children, those who had non-wage income, and those who were self-employed. 
  • Depending on the amount of the under-withholding, and whether or not you compensate for it before the deadline, under-withholding penalties can apply. 
  • There are a variety of waivers you can qualify for to avoid this penalty. 

The GAO Report

Your employer is required to withhold taxes from your pay based on withholding tables provided by the IRS. Historically, withholding allowances have been based on personal exemptions, like the number of children or marital status, but these exemptions no longer exist due to changes made in the Tax Cuts and Jobs Act (TCJA).

Now, income tax withholding is based on the employee's expected filing status and the standard deduction for the year. In addition, taxpayers can choose to have itemized deductions, the Child Tax Credit, and other tax benefits reflected in their withholding for the year.

If you want to learn more about how changes to taxes may affect you, there are two documents that can help, both from the IRS. Publication 5307, titled Tax Reform: Basics for Individuals and Families, and Publication 5318, titled Tax Reform: What’s New for Your Business, are great places to start. 

Why Under-Withholding Is a Problem

The U.S. tax system operates on a "pay as you go" (sometimes called "pay as you earn") basis, meaning you are required to have taxes withheld or pay estimated taxes during the tax year. The elimination of the personal exemption, changes to withholding tables brought on by the TCJA, and the fact that taxpayers were encouraged, but not required, to file an updated W-4 Form may have resulted in under-withholding of taxes for millions of taxpayers.

People Who Should Be Concerned

According to the GAO, a married taxpayer with two children who earns $180,000 annually, including $20,000 from non-wage income—and who itemizes deductions—is a likely candidate for under-withholding. You may also find yourself under-withholding in the following circumstances:

  • You itemized in the past but now plan to take the higher standard deduction.
  • You are part of a two-wage earner household with no children or children age 17 or above.
  • You have self-employment or other non-wage income.
  • You received year-end bonuses, stock dividends, or capital gains.
  • You owe the alternative minimum tax or tax on the unearned income of minors.
  • You realized a profit from property sales.
  • You live in a high-tax state and are losing part of your state and local tax (SALT) deductions.
  • You have significant unreimbursed employment-related expenses no longer deductible under TCJA.
  • You have gambling winnings for which taxes were not withheld.

If any of these apply to you—and you also failed to update your withholding—the risk of under-withholding is even greater.

When the Penalty Kicks In

Typically, an underpayment penalty may apply if the amount withheld (or paid through estimated taxes) is not equal to the smaller of 90% of the taxes you owe for the current year or 100% of the taxes you owed for the previous year.

If a penalty applies, it is typically 0.5% of the amount owed for each month that amount was unpaid. Also, the IRS may charge interest on the amount of underpaid taxes. Each quarter, the IRS sets that interest rate, and for Q4-2021, it's 3% above the federal short-term rate. Please consult a tax professional to determine your exact interest rate.

Additional Available Waivers

The penalty may also be waived under these circumstances.

  • You owed no taxes last year.
  • You have a tax liability (minus payments already made) for this year of less than $1,000.
  • You missed an estimated payment due to a casualty, disaster, or other unusual circumstances.
  • You retired after reaching age 62, and that was the cause of the under-withholding.
  • You became disabled during the previous or current tax year and failed to make estimated payments for that reason.
  • You had any other situation in which underpayment was not due to willful neglect on your part.

Even if you don’t qualify for a waiver, you may be eligible for a reduced penalty in certain circumstances, including a change in marital status or substantial income realized late in the year.

What You Should Do

Determine whether you under-withheld taxes. The 2020 version of Form 1040 and instructions are on the IRS website, along with many supplemental forms and schedules.

File Form 2210

If you under-withheld taxes last year, you must file Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, with this year's income tax return no later than April 15 or tax day.

Complete Part I of Form 2210 and the included worksheet and instructions to determine whether a waiver applies in your case.

If a waiver does not apply, you will likely owe a penalty. In some cases, the IRS will figure the penalty for you, while in other cases, you must use Form 2210 to figure the penalty yourself. See Form 2210, instructions, and worksheet for more information.

The Bottom Line

Check your eligibility for the waiver as well as other waivers for which you might qualify.

If you under-withheld last year, whether you qualify for a waiver or not, check your withholding to avoid this problem in the future. Use the updated online IRS Tax Withholding Estimator to help you adjust withholding amounts.