Have you ever felt like tax rules are a minefield?  That’s where safe harbors come in handy.

A safe harbor is essentially the IRS saying, “Follow these specific guidelines, and you won’t get penalized—even if someone might question your tax situation later.”  It’s like having a protective umbrella. As long as you stay under it, you’re covered.

Some people first encounter safe harbors when they no longer have taxes withheld from their paychecks. Others learn about safe harbors when contributing to an employer-sponsored retirement plan. While the safe harbors in these situations are very different, the concept is the same: follow the rules to avoid penalties.

Here’s how the safe harbor rules work with estimated taxes:

Estimated (quarterly) tax payments are required when insufficient, or no tax is withheld. Examples of income that are typically not subject to tax withholding include self-employment, investment (dividends and interest), private partnerships, and rental properties. While it would be nice to delay paying any tax until filing an income tax return, the US has a “pay-as-you-go” tax system that, in most cases, requires payment throughout the year.

Following the IRS safe-harbor rules for quarterly payments will significantly reduce the likelihood of underpayment penalties. To avoid those penalties, taxpayers must pay tax equal to the lesser of:

• 90% of the current year’s tax, OR
• 100% of the prior year’s tax (bump that to 110% if adjusted gross income exceeds $150,000).

So, even if additional tax is due with the final income tax return, penalties can be avoided if the safe harbor rules are followed.

Here’s how safe-harbor rules work with employer retirement plans:

Most employees don’t think about the complex rules their employer-sponsored retirement plans must follow. Employees enroll in the 401(k) or 403(b) plan, set their contribution, select investments, and move on. However, high-earning employees may be surprised when their contributions (and earnings on those contributions) are refunded to them because the plan fails complex IRS nondiscrimination tests. If the employee’s contributions to the plan were pre-tax, those contributions are taxable upon refund. So, the employee is faced with a double-whammy…less money saved for retirement and a higher tax bill. And the employer may face IRS penalties due to a noncompliant plan.

Fortunately, employers can easily establish safe-harbor retirement plans that automatically meet IRS requirements. These plans require mandatory, immediately vested employer contributions for all eligible employees. Under a safe-harbor plan, highly paid employees can max out their contributions without worrying about potential issues.

The bottom line:

Safe harbors provide certainty and peace of mind. Both taxpayers and the IRS benefit from clear guidelines that prevent penalties.

The trade-off? Following safe harbor rules might not always result in the lowest tax bill, but the peace of mind may be worth it.

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Mosaic FI, LLC is a State of Illinois registered investment adviser. This newsletter is for general informational purposes only and does not constitute tax, legal, or accounting advice; it does not consider the objectives, financial situation, or needs of any individual. Tax laws and regulations may change; consult a qualified tax professional for advice tailored to you.

Any references to “safe harbors” describe general IRS rules intended to reduce underpayment penalties when applicable criteria are met; they do not guarantee lower overall tax liability or eliminate all penalties.