How payroll tax rules can help you avoid tax underpayment penalties

The April Surprise

With tax season upon us, what better way to kick off the first newsletter of the year than with a tax topic :)

Let’s imagine last year was the best financial year of your career. Your company stock appreciated significantly, a bunch of RSUs vested, and you received a performance bonus. Things felt secure. You assumed your company withheld enough taxes from those windfalls.

Then April comes.

You’re expected to write a check for the difference between what was withheld from your paycheck and what you owed. What you didn’t expect was an additional underpayment penalty. You had the cash to pay the tax, so this is just an annoying and unnecessary expense.

What you probably don’t realize: the U.S. tax system operates on a pay-as-you-go basis.

When taxes aren’t paid throughout the year as income is earned, the IRS may assess interest and penalties, even if the full balance is paid by the filing deadline.

This situation is common among higher earners who earn employer stock. The next time you find yourself late in the year (Oct/Nov), remember that the IRS is still looking backward at what wasn’t paid earlier in the year. In some situations, there may still be a way to reduce or eliminate penalties by using how payroll withholding is treated under IRS rules.

Why do high earners sometimes owe tax penalties on things like RSU income?

The issue usually comes down to how federal tax withholding rules apply to supplemental income (which is what RSU income technically falls under).

Under current federal rules, employers are generally required to withhold a flat 22% on supplemental wages (such as RSUs, bonuses, and nonqualified stock option exercises).

For many high earners, the actual tax rate may be much higher. Often 32%, 35%, or 37%, depending on overall income and filing status.

This creates a gap. For example, if $100,000 of RSUs vest, $22,000 may be sent to the IRS through withholding, while the eventual tax liability could be meaningfully higher. That difference isn’t inherently a problem, but if it isn’t addressed throughout the year, it can contribute to an underpayment penalty.

Many taxpayers assume they can simply reconcile everything at filing time. However, because the IRS evaluates taxes based on when income is earned, interest may accrue on underpaid amounts from earlier quarters. This can easily amount to thousands of dollars.

How payroll withholding is treated differently

Here’s where an important distinction comes into play.

When you make estimated tax payments directly to the IRS, the IRS applies those payments to the specific quarter in which they’re received. Sending a payment late in the year doesn’t retroactively fix underpayment penalties from earlier quarters.

Payroll withholding is treated differently.

For IRS accounting purposes, federal income tax withheld from your employment wages (i.e., your paycheck) is generally treated as if it were paid evenly throughout the year, regardless of when the withholding actually occurred.

This means that increasing withholding later in the year (by adjusting your W-4 with your HR team) may help offset underpayments from earlier quarters when the IRS calculates penalties. It doesn’t change the total tax owed, but it can affect how and when payments are credited, which could completely eliminate any penalties.

You can approach this strategically by evaluating where your situation is at during the fall each year. If you’re coming in too low, you can adjust the rest of your paychecks.

This approach isn’t appropriate for every situation, and it depends on income timing, prior-year taxes, and safe harbor tax rules. But in some cases, it can materially reduce or eliminate underpayment penalties.

FAQ

How much do I need to pay to potentially avoid penalties?

For taxpayers with adjusted gross income over $150,000, the most commonly used safe harbor (i.e., minimum amount to pay to prevent penalties from piling up) requires paying 110% of the prior year’s total tax liability through withholding and/or estimated payments. Meaning you pull your tax return from last year, reference form 1040 (usually the first page), and reference line 24. Multiply that by 110%, and as long as you withhold that amount, you won’t accrue penalties (but oftentimes, you’ll still owe more when you make your filing).

Another safe harbor is paying 90% of the current year’s tax liability, though that can be difficult to estimate accurately when equity compensation is involved.

Can this apply to ESPP sales?

ESPP sales themselves are capital transactions and don’t involve payroll withholding. However, some individuals increase withholding on regular wages to help cover the tax impact of ESPP gains.

Is there a limit to how much I can withhold?

Payroll systems generally limit withholding to the amount of your net pay in a given pay period. This practical limitation often determines how much flexibility exists late in the year. This is another reason not to wait until too late in the year (i.e., December) to make up a shortfall. You might not have enough paychecks left to make up a shortfall.

Your Next Steps

1. Review last year’s total tax (Form 1040, Line 24).

2. Compare that figure to your year-to-date federal withholding on your paystub. Do not add in Social Security and Medicare taxes. This is only related to federal taxes.

3. Identify any potential shortfall relative to a safe harbor threshold.

4. Review your W-4 to understand how additional withholding would be implemented.

5. Consider how upcoming bonuses or equity events may affect your year-end tax picture.

Because individual circumstances vary, coordinating with a tax professional is often advisable before making major changes.

Meme of the Week

Keep Perspective

A strong income year can bring unexpected tax complexity. Understanding how withholding rules work and their limitations can help you make more informed decisions before year-end.

If you’re tired of unexpected tax bills ruining your April, reach out and let us solve that problem for you once and for all.

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Marcel Miu, CFA and CFP® is the Founder and Lead Wealth Planner at Simplify Wealth Planning. Simplify Wealth Planning is dedicated to helping tech professionals master their money and achieve their financial goals.

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