Underwithholding: What it Means and How It Works

Definition

Underwithholding occurs when an employer (or payor) does not withhold enough tax from a taxpayer’s wages or other income during the year to cover the taxes owed. The shortfall must be paid when the tax return is filed and may trigger an underpayment penalty.

How withholding is determined

Withholding is set based on factors such as:
* Income level
* Filing status (single, married filing jointly/separately, etc.)
* Number of dependents or allowances claimed
* Any additional dollar amount the taxpayer requests to be withheld

Taxpayers record these choices on Form W-4 with their employer. Withholding reduces the amount due when filing an annual return; insufficient withholding increases the likelihood of owing tax at filing.

Common causes of underwithholding

• Not updating Form W-4 after a life or income change (marriage, divorce, new job, raise)
• Income from sources that don’t withhold (freelance work, side gigs, investment income)
• Claiming too many allowances or otherwise reducing withholding intentionally
• Miscalculating expected deductions or credits

Consequences

If you underwithhold, you generally must pay the unpaid tax when you file. The IRS may also assess a penalty for underpayment unless you meet one of these safe-harbor tests:
* You paid at least 90% of the tax you owe for the current year, or
* You paid 100% of the tax shown on your prior year’s return (taxpayers may use whichever threshold is smaller)

Exceptions can apply — for example, if the unpaid tax is less than $1,000 or if you had no tax liability in the previous year, you may avoid the penalty.

Intentional underwithholding — risks and motivations

Some taxpayers intentionally reduce withholding to have more take-home pay or to invest withheld funds themselves. While this can increase short-term cash flow and potentially generate returns, it carries risks:
* Owing a large tax balance and possibly a penalty at filing
* Potential legal risk if false or fraudulent information is provided on Form W-4

Overwithholding — the other side

Overwithholding means more tax is taken out than necessary, resulting in a refund when you file. The trade-off is that you effectively give the government an interest-free loan during the year.

How to avoid or fix underwithholding

• Review paystubs and prior-year tax bills regularly.
• Use the IRS Withholding Estimator or similar tools to check whether your withholding matches your expected tax liability.
• Update Form W-4 with your employer whenever your situation changes.
• Make estimated tax payments if you have significant income not subject to withholding.
• Consider withholding an additional flat dollar amount on your W-4 if you expect a shortfall.
• Consult a tax professional for complex situations.

Key takeaways

• Underwithholding means you didn’t pay enough tax through the year and may owe a balance and penalty at filing.
• Withholding is set via Form W-4 and depends on income, filing status, and withholding choices.
• To avoid surprises, monitor withholding, update your W-4 after changes, and make estimated payments for nonwage income.