Underwithholding: What It Means, How It Works

WHAT IS Underwithholding

Underwithholding refers to a specific tax situation in which an individual did not withhold enough taxes from their wages to cover their tax obligations.

BREAKING DOWN Underwithholding

Underwithholding occurs when an individual does not withhold enough taxes from wages or other income to cover what they owe to tax authorities. Withholding is the portion of an individual’s wages that is taken out of their paycheck to cover federal, state, and local taxes. The IRS calculates federal tax withholding based on income, marital status, and choices made by the taxpayer, such as the number of dependents claimed and filing status. Taxpayers can also choose to have additional money withheld or request a reduction in withholding if they expect significant deductions. These preferences are registered with employers using Form W-4 Employee’s Withholding Certificate.

Paying taxes directly from each paycheck reduces the amount owed when an individual files their annual tax return. If an individual hasn’t paid enough throughout the year to cover their tax obligations, they must pay the balance when filing their income taxes. In addition, a penalty fee may be charged for significant underwithholding. To avoid this penalty, individuals must have paid at least 90 percent of taxes owed in the current year or 100 percent of those owed the previous year (using the smaller figure). However, even if the threshold isn’t met, a penalty can be avoided if the unpaid tax is less than $1,000 or if there was no tax liability the previous year.

Why Choose to Underwithhold?

Some individuals deliberately choose to underwithhold in order to invest funds that would have been withheld and potentially turn a profit after paying income taxes. However, excessive underwithholding can result in a penalty. Additionally, reducing withholdings by claiming more allowances than entitled to on the W-4 form can lead to charges of supplying false or fraudulent information.

Underwithholding’s Opposite: Overwithholding and its Benefits

On the other hand, an individual may choose to overwithhold by withholding more than they will likely owe in income tax. This results in a tax refund after filing a return. However, overpaying taxes essentially gives the Internal Revenue Service an interest-free loan.