Federal employees who did not track their federal income withholding from their paychecks during 2023 may be in for a shock this spring when they file their 2023 federal income tax returns.
As of October 1, 2023, the IRS is charging 8 percent interest on estimated tax underpayments, an increase from 3 percent the IRS charged for underpayments during 2021. The increase is one of the many effects of rising interest rates.
Most federal employees request that their agencies withhold federal and state income taxes from every paycheck they receive. Many employees are due a refund when they file their annual tax return, a result of having overpaying through withholding.
This is also true for most employees who work in private industry. Still, the IRS assessed more than $1.8 billion in penalties for underpaying federal income taxes during 2022.
Beyond underpayment penalties, the higher total federal income tax bills for millions of Americans increase the risk that many individuals will not be able to pay their full balance in April when they file their federal income tax return. Failing to pay all of one’s federal income tax bills can lead to more IRS penalties and – in the worst case – IRS collection actions including liens and levies.
The U.S. tax system is a “pay-as-you-go” system. This means individuals should make tax payments as they earn and receive taxable income. Making regular tax payments can be done through regular income tax withholding and by making quarterly estimated tax payments.
In order to avoid underpayment penalties, most individual tax filers must pay 90 percent of their annual federal tax liability through federal income tax withholding (from their paychecks, or retirement payments withdrawals such as the TSP) or through estimated payments due quarterly.
The payment deadline for the fourth quarter of 2023 federal estimated tax payment is January 16, 2024. The IRS will not charge an underpayment penalty if an individual’s balance due is less than $1,000 when the 2023 federal income tax return is filed this spring, after taking into account federal income tax withholding, estimated tax payments and tax credits.
Suggestions to Avoid Under Withtholding Penalties
The following are some suggestions for federal employees and retirees to keep their federal income tax payments on track in order to avoid under withholding penalties:
• Adjust federal income tax withholding as early in the calendar year as possible.
Federal employees who are withholding too little from their paychecks can change their recurring tax withholding or withhold an additional dollar amount by completing and submitting a revised Form W-4 with their payroll office. Federal retirees who are receiving CSRS or FERS annuity checks can request that OPM withhold additional federal income tax each month from their monthly annuity checks.
The IRS considers the extra withholding to be spread evenly throughout the year, which helps lessen or eliminate underpayment. Thos employees and retirees who know that the bi-weekly or monthly federal income withholding was insufficient during 2023 should request additional federal income tax withholding as soon as possible now in January 2024.
• Make estimated tax payments.
If additional federal income tax withholding is not an option, then estimated tax payments need to be made. If a federal employee knows that he or she underwithheld during 2023, a fourth quarter federal estimated tax payment should be made. The due date is January 16, 2024. It is fairly painless to pay electronically through IRS Direct Pay (https://www.irs.gov/payments/direct-pay) or setting up an account with the Treasury Department’s Electronic Federal Tax Payment System (EFTPS) (https://www.eftps.gov/eftps/).
• Avoid underpayment penalties.
Employees and retirees can avoid being subject to an under-withholding penalty by paying in, through withholding and estimated tax payments, at least 90 percent of the current federal tax liability or 100 percent of the previous year’s federal tax liability. The 100 percent figure increases to 110 percent for individuals with adjusted gross income of more than $150,000 ($75,000 if filing as married filing separately).
• Request a penalty waiver.
The IRS will waive estimated tax penalties in limited cases, including for individuals who recently retired after reaching 62 or become disabled and the underpayment arose from reasonable cause. IRS Form 2210 (Underpayment of Estimated Tax by Individuals, Estates and Trusts) instructions explain this.
Those federal employees and retirees who are residents of states with state and local income taxes are advised to check with their state revenue and tax departments to find out what their states require with respect to state and local income tax withholding.
States have their own penalties with respect to state income tax under withholding. These states advise residents who are having an insufficient amount of state and local income taxes withheld from their salaries and retirement distributions including traditional IRAs to make quarterly estimated state income tax payments. State estimated tax payments for most states can be done online.