When it comes to income taxes, there is no shortage of rules, acronyms, and best practices. One such “tax term” came up this week as I worked thru a retirement plan distribution for a client. Find out what “safe harbor” means in terms of estimated income tax payments and why it’s a strategy you should employ.

Estimated Tax Payments

Before we dive into safe harbor, let’s refresh our memories on income tax payment rules, namely it’s a “pay as you earn” system. This means that you need to make some level of tax payments (either via payroll withholding or via direct estimated payments to the IRS) as you move thru the tax year. You cannot wait until tax due date to submit all your tax owed (well, not unless you want to pay interest and penalties!)

Individuals that are employed will automatically make regular tax payments (via payroll withholdings) however, even still, estimated payments may be required on other income (pensions, investments, social security, self employment income, etc). As a result, care must be taken to ensure you have a plan in place to remit the necessary tax payments on time during a given tax year.

Searching for a Safe Harbor

If you’re following along at home, you may have a good question in mind. How are you supposed to ensure you pay the right amount of tax when the year isn’t over yet and you don’t know how much you will ultimately owe? That is an excellent question and can prove very difficult to answer accurately depending upon your tax situation and its variability in any given year. This is where the term safe harbor comes into play as it relates to income taxes.

Safe harbor is a broad legal term. You reach “safe harbor” by complying with the terms and provisions provided in the agreement/situation. If you do so, you are protected from any resulting penalties and eliminate legal or regulatory liability.

In terms of income taxes, safe harbor is available for estimated tax payments if you meet the following criteria:

Pay the lesser of the current year method or the prior year method:

Current year method: pay in at least 90% of the tax you think you will owe for the current year (can be challenging if you don’t know what current year looks like) OR

Prior year method: pay in 100% of the tax you owed for the previous tax year (this increases to 110% if your prior year adjusted gross income was over $150,000 married/$75,000 married filing sep)

OR be confident you will own less than $1,000 (after withholdings and credits) in which case no estimated payments are due

Keep in mind that your state may have its own set of safe harbor rules.

With another tax payment date coming up soon (June 15th) take a look at your situation and verify your estimated tax payments are on track!