Ever since World War II, the Internal Revenue Service has required taxpayers to pay their taxes as they earn income throughout the year, rather than just as a lump sum with their income tax return filed at the end of the year. That way, instead of having to chase taxpayers down for the full amount, when taxpayers file their return, they either pay just the amount of the shortfall from withholding, or they get a refund of the overpayment.
However, the IRS treats underpayments and overpayments differently when it comes to interest and penalties. The IRS does not penalize you for paying in too much in taxes during the year. Instead, you will receive the amount of the tax overpayment back as a refund.
Calculating Tax Liability
To figure out whether you owe or will receive a refund when you file your taxes, you need to know how much you owe in taxes and how much you paid in throughout the year through estimated payments and tax withholding. You can find out how much you had withheld from your paycheck for federal income taxes by looking at your pay stubs or the Form W-2 your employer completes for you at the end of the year.
On your Form W-2, your federal income tax withheld is showing in box 2. If your withholding exceeds your tax liability, you’ve overpaid your taxes for the year.
When You Pay Too Much
If you paid in too much tax through income tax withholding or estimated tax payments, you get credit for the overpayment when you file your income tax return. Instead of having to pay money with your income tax return, the IRS will refund the excess to you.
According to the IRS, most refunds are issued within 21 days. However, it could take longer if your return is incomplete, has errors, is affected by identity theft or fraud, if you’re claiming certain tax credits or if it needs further review. You can check the status of your income tax refund on the IRS website under “Where’s My Refund?”
No IRS Overpayment Penalty
The IRS doesn’t charge you a tax overpayment penalty if you pay too much in estimated taxes. When you file your tax refund, you will simply receive a refund for whatever excess you paid in during the year, either through estimated tax payments or tax withholding from your paycheck, without the IRS charging you a penalty for holding your money.
In fact, some people intentionally have too much withheld from their taxes as a way to force themselves to save money each pay period. Once the money is withheld from your paycheck, you can’t get to it until after you’ve filed your tax return and received a refund from the IRS. That way, you won’t be tempted to raid your savings throughout the year for impulse purchases.
Read More: What Happens If You Don't File Taxes?
Downsides of Underpayment
However, overpaying your taxes isn’t completely without cost. While the IRS won’t penalize you, it also doesn’t pay you interest on the excess it was holding throughout the year. Depending on how you would have used the money had you had it during the year, that could be costing you more than you realize.
For example, say you receive a $3,600 income tax refund when you file your return. While that sounds fantastic, when you do the math, that comes out to $300 extra withheld each month. If you have credit card debt charging you high interest, you could have been using that money to pay off the debt faster, rather than racking up additional interest.
Penalties for Tax Underpayment
Though there aren’t penalties for overpaying your taxes, the IRS does impose penalties for underpaying your taxes. You are required to pay taxes as you earn income throughout the year. While you might not remember ever writing the IRS a check during the middle of the year, that’s because, for most people, the money withheld from your paychecks by your employer meets your minimum withholding requirements.
If, however, you have other income that isn’t subject to withholding, such as investment income or self-employment income, you may need to make estimated tax payments throughout the year to meet the minimum amount of income tax withholding. Typically, people make four equal quarterly payments.
Avoiding Underpayment Penalties
To avoid an underpayment penalty, you must meet one of several tests the IRS sets out for determining the minimum amount you need to have withheld. First, if your withholding and estimated payments combined leave you owing less than $1,000, you won’t owe any penalties. Second, you won’t owe any interest or penalties as long as you paid 90 percent of your total tax liability.
For example, say when you file your tax return your total tax liability, before withholding or estimated payments are applied, is $15,000. To avoid interest and penalties, the tax code requires your withholding and estimated tax payments to be at least $13,500.
Paying Everything You Owe
The final way is based on your tax bill from the prior year – in most cases, you can avoid penalties if you pay at least 100 percent of what you owed last year. The percentage is a little higher, but because you know what your tax liability from the prior year is and your current year’s tax liability could fluctuate, some taxpayers prefer to rely on it because it’s more certain.
If your adjusted gross income last year was $75,000 if you’re married filing separately or $150,000 or less if you use any other filing status, you won’t owe any interest or penalties if you pay in at least what you paid in taxes the prior year. For example, if last year your tax liability was $8,000, you must pay in at least $8,000 and you won’t owe any interest or penalties.
If your adjusted gross income exceeded $75,000 if you’re married filing separately or $150,000 if you use any other filing status, you must pay in at least your tax liability for the prior year plus 10 percent (110 percent). So, if your adjusted gross income was $160,000 last year and your tax liability was $13,000, you would need to pay in at least $14,300 to avoid interest and penalties. But, even if you had an amazing year from an income perspective and owed $30,000 in taxes, you wouldn’t be charged any interest or penalties on the underpayment.
IRS Penalty Waiver
You don’t want to count on the IRS exercising its discretion to waive the penalty, but the tax code does permit waivers in two circumstances.
First, if a natural disaster, casualty event or other unique circumstances prevented you from paying in the amount you were required to in tax withholding, the IRS can waive the penalty if it would be inequitable to charge you for it. Second, if you are at least 62 and retired during the current tax year or the prior tax year, or if you became disabled during either year, and you didn’t make the minimum payments because of a reasonable cause, the IRS can also, at its discretion, agree to waive the penalty.
How Employers Calculate Tax Withholding
The Form W-4 is the form that you submit to your employer so your employer can properly calculate how much to withhold from your paycheck. Besides your income, which your employer already knows, your Form W-4 tells your employer what filing status to use and how many dependents you are claiming.
If you’re unmarried, you only have one option when it comes to your filing status for tax withholding purposes: single. If you’re married, you actually have a choice. You can either opt for your employer to withhold money at the married rate or the single rate. The married rate reflects the lower tax brackets for married couples who file joint returns, so your withholding will be less. However, if you are planning to file as married filing separately, or prefer to have additional money withheld to receive a bigger refund, you can have your employer still withhold taxes at the higher single rate.
The form has had a makeover in 2020, and you no longer claim personal allowances. The intention is to make it easier to complete the form, and ensure the withholding is enough to meet the income tax withholding requirements. If it isn't, you could owe additional interest and penalties. You can still face a $500 penalty if you knowingly filled out a false Form W-4.
How to Avoid Overpaid Tax
If you have paid in too much tax and don’t anticipate a change in your tax circumstances for the coming year, consider reviewing your Form W-4. Consider reviewing your withholding after major life changes, such as getting married or divorced, having a child or having a child become an adult, changing jobs, getting a substantial raise or taking a substantial pay cut, or starting a second job or side hustle.
You can submit a new Form W-4 at any time. However, because withholding occurs throughout the year, you should submit a new Form W-4 as soon as possible after changes occur. Once received, your employer must start using the new information to calculate how much to withhold from your paycheck for income taxes for the first pay period that starts at least 30 days after you submit the new form.
For example, say you turn in a new Form W-4 on Sept. 1. Your employer must start using the new information to calculate your withholding no later than the first pay period that begins on Oct. 1 or later.
- IRS: Topic Number 306 - Penalty for Underpayment of Estimated Tax
- IRS: Form W-2
- IRS: Topic Number 753 - Form W-4 – Employee's Withholding Allowance Certificate
- IRS: Publication 15
- IRS: Form W-4
- Internal Revenue Service. "Tax Withholding Estimator." Accessed Oct. 23, 2019.
- Internal Revenue Service. "Tax Withholding and Estimated Tax For use in 2019," Page 10. Accessed Oct. 24, 2019.
- Internal Revenue Service. "Part III – Administrative, Procedural, and Miscellaneous: Relief from Addition to Tax for Underpayment of Estimated Income Tax by an Individual," Pages 1–2. Accessed Oct. 24, 2019.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."