What is the safe harbor rule?

For individuals and families who pay (or should pay) quarterly estimated taxes, there’s a term called “safe harbor” that you should be familiar with because it could save you time and money.

Generally, if you don’t pay the IRS enough taxes, they will charge you interest and payment penalties. However, as long as the amount you pay the IRS this year is as much as you paid the IRS last year, the safe harbor rule ensures that the IRS can’t charge you any penalties or interest.

A simple example can help make this more clear:
Let’s assume John Doe, who owns a small construction business, made $80,000 last year and paid the IRS a total of $16,000 in taxes, by filing payments of $4,000 per quarterly payment in estimated taxes. This year John made $100,000 and will owe the IRS more for income taxes. However, knowing the safe harbor rule, John can make the same $4,000 quarterly payments this year and cannot be charged interest or underpayment penalties by the IRS. He will ultimately have to pay his full tax liability, which might be $20,000 if his tax rate does not change from last year, but because of the safe harbor rule, he can wait to pay the difference between $16,000 and $20,000 until he files his taxes in April.
Many people will use the safe harbor rule when filing their quarterly tax payments with the IRS. If you have more income this year than last year, you should consider simply paying ¼ of last year’s taxes for each quarterly payment this year, which will result in an interest free loan from the government until it’s time to even-up in April. One more thing to note: if your income exceeds $150,000 per year, then the rule is slightly different, and you should ensure you pay 110% of last year’s taxes to avoid penalties.

If your income is equal to, or less than, last year’s income, none of this applies to you. But, if you can take advantage of the safe harbor rule when you pay your quarterly estimated taxes, it’s a great way to get a free loan from Uncle Sam, and a simple way to determine what your quarterly tax payments should be to avoid penalties.
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