Federal income taxes are “pay-as-you-go,” according to the IRS. This means you must pay most of your tax throughout the year as your income is received, rather than waiting until you file your tax return to make up for any shortfall. Paying as you go will not only help you avoid a large tax bill when filing your tax return, it should also help you avoid a penalty for the underpayment of estimated tax.

Generally, you will not be subject to an underpayment penalty if you owe the IRS less than $1,000 after factoring in all tax payments. Tax payments include taxes withheld from your paychecks, estimated tax payments, refundable credits, and any portion of the prior year’s refund applied to the current year’s taxes. If your tax bill is $1,000 or greater, you may still avoid the underpayment penalty if either of the following scenarios applies.

1. Your tax payments for the year are at least 100% of your prior year’s tax liability.
   This threshold increases to 110% if your prior year’s adjusted gross income is more than $150,000 (or $75,000 if you are married filing separately).
   
   EXAMPLE
   Last year, Chip had income of nearly $37,000. Chip’s tax liability was $5,000. Because Chip’s tax payments for the year totaled $7,500, he received a $2,500 refund.
   
   This year, Chip’s income nearly doubled. His income tax liability jumped to $12,000. Chip once again made tax payments totaling $7,500. Even though Chip has a shortfall of $4,500, he avoids the underpayment penalty because this year’s tax payments ($7,500) were at least 100% of last year’s income tax liability ($5,000).
   
   
2. Your tax payments for the year are at least 90% of the ultimate income tax liability for the current tax year.
   
   EXAMPLE
   Last year, Michael had a tax liability of $35,000. When Michael retired this year, he anticipated his total income tax liability would drop to about $18,000. As a result, he chose to withhold $18,000 from his various retirement income streams. When filing his taxes, Michael’s CPA informs him that his tax liability is actually $20,000. Although Michael has a shortfall of $2,000, he avoids the underpayment penalty because he paid in at least 90% ($18,000) of his ultimate tax liability ($20,000).

As illustrated above, the estimated tax penalty may be avoided with a bit of planning. Be sure to consult with a qualified tax professional if you are concerned you may be subject to the penalty in the future.