Tax Season is Here: Are Your Withholdings on Track?

April 15 might still feel far away, but as the tax filing deadline approaches, you might hear people saying, “My refund was huge” or “I can’t believe I owed that much this year!” With these phrases common, taxpayers may need a reminder about why they received a refund or a big bill.

Basically, it comes down to how well you’ve estimated your income and adjusted your withholdings throughout the year. Sounds simple, right? Unfortunately, as with most things tax-related, there’s a maze of rules and withholding requirements to navigate. Let’s break it down.

Understanding Tax Withholdings

A century ago, U.S. taxpayers made one lump sum payment at year’s end. However, as incomes grew, the tax system evolved into a “pay-as-you-go” approach, requiring employers to withhold taxes from paychecks. This system makes it easier on the taxpayer to set aside income from each paycheck for both state and federal taxes.

However, your employer doesn’t pluck your withholdings out of thin air; instead, you’re required to withhold at least your safe harbor amount. This varies depending on your income taxes paid in the preceding year and your adjusted gross income (AGI).

In short, to meet the safe harbor rule, taxpayers must withhold either:

100% of last year’s tax liability (or 110% if income is over $160,000), or
90% of this year’s expected liability, whichever is less.

Many employers automatically withhold enough to meet these requirements, but mistakes can happen. It’s a good idea to check with HR to monitor withholdings, especially if you have additional income sources from outside business activities or a side hustle.

Your withholding amounts are also determined by allowances, which are essentially tax deductions that reduce how much is withheld. Factors like dependents, mortgage interest, and charitable deductions can help reduce a taxpayer’s required tax withholding.

Estimated Tax Payments: What Business Owners Need to Know

While employees rely on withholding from paychecks, small business owners and self-employed individuals must make quarterly estimated payments to the IRS to ensure that they meet their safe harbor requirements. These payments should be made ratably throughout the year, meaning you should pay around 25% of your total tax liability each quarter.

Missing estimated payments or underpaying can result in significant penalties. The rules for estimated payments are similar to withholdings:

Sole proprietorships, partners, and S Corp shareholders need to make quarterly estimated payments if they expect to owe more than $1,000 in a given year.
Corporations are required to make quarterly estimated payments if they are expected to owe at least $500.

These estimated payments are subject to the same rules as personal safe harbor amounts. That is, you must withhold either 100% of last year’s tax liability or 90% of this year’s expected tax liability.

For example, if you owed $10,000 in taxes last year from your sole proprietorship, you’d have to withhold $2,500 each quarter of this year. That means even if on January 2 you won a billion-dollar lottery jackpot, your minimum quarterly tax withholding would still be only $2,500 – at least until the following tax year!

Tax Planning Strategies for Business Owners

Understandably, many business owners don’t want to cut the IRS a check every few months to meet their mandatory withholdings. These funds could instead be better utilized back in the business. The good news is there are plenty of strategies to legally reduce your taxable income and, in turn, your required estimated payments:

Charitable contributions – Giving to charity can lower your taxable income, reducing your estimated tax bill.
Retirement plan contributions – Contributing to a SEP IRA, solo 401(k), defined benefit plan or other retirement plans can provide major tax savings.
Income deferral – Pushing income into the next tax year can help reduce your tax burden for the current year.

With prior planning, each of these mechanisms can reduce a business owner’s taxable income, freeing up cash flow. However, tapping into these tools might not make sense if they don’t fit your overall financial goals. Aligning your cash flow and spending with your long-term objectives is always the most important consideration. Bottom line: Don’t let the tax tail wag the dog!

The Cost of Missing Payments: Penalties Explained

Failing to meet estimated tax payment deadlines can result in significant penalties. For payments due on January 15, 2025, the penalty is 7% of the underpaid amount. For example, a taxpayer who underpays their required estimated payment amount by $5,000 in January will owe an additional $350 in penalties (or $87.50 per quarter) when they file their annual return.

Taxpayers who have missed their quarterly estimated payments have a few options:

Pay the IRS what you owe – It’s painful, but it stops further penalties from accruing.
Withhold from a year-end bonus – If you’re an employee, ask your employer to withhold extra taxes from a year-end bonus.
Push income into the next year – If possible, delay receiving income, bonuses, or contracts until the new tax year to avoid an immediate tax bill.
Use an IRA distribution strategically – Withholding taxes from an IRA distribution can be an effective way to make up for missed estimated payments.

Unlike estimated tax payments, withholdings are treated as if they were made evenly throughout the year, even if they happen in December. This means that taking a large IRA distribution that is completely withheld before year-end could help erase underpayment penalties. Just make sure you can roll the funds back into a qualified retirement account within 60 days.

Why You May Need a Tax Strategy Team

As the tax code becomes increasingly complex, keeping up to date with ever-changing legislation is difficult, and likely outside the scope of a business owner’s duties. Mistakes, even honest ones, can be extremely costly. This is where professional advice comes into play. Popular tax planning and reporting software often lacks the sophistication or nuance required to accurately identify, recommend, and implement multiyear tax strategies. These mistakes may lead business owners to withhold more of their income than needed, reducing free cash flow.

For those with high incomes and tax complexity, having both a Certified Financial Planner (CFP®) and a Certified Public Accountant (CPA) on your team can make a difference.

Your financial advisor or CFP will incorporate tax minimization strategies into your long-term financial plan while keeping up to date with legislative updates and new planning opportunities.
Your CPA’s primary focus is to ensure your taxes are filed accurately and timely.

Whether you’re an employee fine-tuning your withholdings or a business owner juggling estimated payments, proactive tax planning can save you time, money, and headaches. Having a professional team coordinate with each other is a fantastic way to make sure there are no gaps in your financial planning picture.

This is for informational purposes only. The information provided does not purport to present a complete picture, but Focus Partners believes the information is representative of issues and needs facing some clients and why they may seek this service. Nor should it be construed as, specific investment, tax, or legal advice. Individuals should seek advice from their wealth advisor or other advisors before undertaking actions in response to the matters discussed. No client or prospective should assume the above information serves as the receipt of, or substitute for, personalized individual advice.

This represents the opinions of Focus Partners, may contain forward-looking statements, and presents information that may change due to market conditions or other factors. Nothing contained in this presentation may be relied upon as a guarantee, promise, assurance, or representation as to the future. This is prepared using third party sources considered to be reliable; however, accuracy or completeness cannot be guaranteed. The information provide will not be updated any time after the date of publication. Numerous representatives of Focus Partners may provide investment philosophies, strategies, or market opinions that vary. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Services are offered through Focus Partners Advisor Solutions, LLC (“Advisor Solutions”) and Focus Partners Wealth, LLC (collectively referred to in this document as “Focus Partners”), SEC registered investment advisers. Registration with the SEC does not imply a certain level of skill or training and does not imply that the SEC has endorsed or approved the qualifications of the RIAs or their representatives. Prior to January 2025, Advisor Solutions was named Buckingham Strategic Partners, LLC, and Focus Partners Wealth was named The Colony Group, LLC.

Source: irs.gov.

RO-25-4234640

February 17, 2025