After dozens of hours poring over paperwork and entering and double checking numbers, I finally filed our household's 2020 taxes this past week. My tax prep software tells me that it would take a whopping 774 pages to print out the entire packet including worksheets were I to do so. That same software also tells me that we're due a modest refund from the federal government.

While it'd be nice to have our money back, I don't expect to see a dime of it in 2021. Instead, I've asked the government to apply our 2020 overpayment toward our 2021 taxes. That's a request it'll certainly oblige, and it's why Uncle Sam is keeping my refund this year.

man looking at wallet while money flies away

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Is that crazy, or what?

At 774 pages of forms, schedules, and worksheets, our tax situation is a little complicated to say the least. At the root of the issue is that we make money from three different sources: standard employment, a small business, and investing.

To add to the complexity, some of that investing income comes from owning bonds and stock options. Those type of investments have expiration dates attached. As a result, they mature and thus force capital gains and/or loss accounting. That drives more paperwork, hence the crazy high page count of our tax returns.

Unfortunately, that complexity also means it's very difficult to get a handle on what we'll really earn (and owe) early in the year. The IRS doesn't require you to get your taxes perfect in advance of your final filing the year, but it does expect you to get close during the year and then true up by the filing deadline. That requirement to get close is behind the decision to apply our 2020 refund to our 2021 taxes.

Close enough and the safe harbor rules

The IRS has three different tests to determine whether you're "close enough" throughout the year with the tax money it receives from you before you file and true up by the filing deadline. Those tests are commonly known as the safe harbor rules, and you only need to pass one of them each year to be considered close enough. The tests are:

  • If you pay within $1,000 of what you owe for the year,
  • If you pay at least 90% of what you owe for the year, or
  • If you pay at least 100% of what you owed for the previous year (110% if you're considered high-income)

As long as you meet any one of those tests through timely estimated payments or withholdings, you're covered by safe harbor. You will still have to file and true up the remainder of what you owe by the filing deadline, but you won't owe any underpayment penalties if you hit one of those three rules and true up the rest on time.

The key challenge with the first two rules is that you need to have a decent estimate of what you'll owe for the year in order to meet either of those two tests. If your income is variable and contingent on the whims of the market, that can be a difficult task. For that third rule, however, you know in advance exactly how much you need to send in if you want to be considered covered by the safe harbor.

Predicting the future is hard

Fortune teller looking at a crystal ball

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Because it's the only one that's knowable in advance, that third safe harbor rule is the one I target for our tax planning early in the calendar year. As the year progresses, I can adjust as reality sets in, but by starting out there, I don't have to make changes throughout the year and at least have a known target to shoot for.

While our income is as unpredictable as ever in 2021, I do have good reason to believe it will be lower than it was in 2020. We had two long-term one-time bonuses that matured and paid out in 2020, and we have none scheduled to do so in 2021. Unless the market makes us a series of offers we can't refuse, it'll be a huge uphill climb for our 2021 income to top 2020's.

Combine a lower expected income with a tax payment plan that is based on last year's higher income, and we find ourselves in a situation where our take-home pay can get seriously squeezed. That's where letting Uncle Sam keep our 2020 refund looks like help. By applying our 2020 refund to our 2021 taxes, it's that much less we have to have withheld throughout 2021 and still wind up covered by a safe harbor.

By giving up our 2020 refund, it translates directly to a larger check every payday for the rest of 2021. While we could have accepted the refund check and used it to cover for the additional withholdings we otherwise would face, interest rates on savings accounts are near zero.  As a result, it didn't seem to be worth the extra hassle for the pennies of interest that money would generate if we held it ourselves.

Find a path to safe harbor coverage for yourself

While that's the safe harbor test I generally follow to attempt to stay in the IRS' good graces, it's not the only way to do so. You can pay sufficient and timely quarterly estimated taxes instead. Alternatively, you can have money withheld on a different schedule that still meets at least one of the safe harbor tests. In years where you expect your tax liability to be lower than the previous year, following a different approach could let you keep more of your money in your pocket throughout the year.

The key trade-off you'll face is that other approaches to staying within the IRS' safe harbor limits require you to be more vigilant. To pass either of the other two safe harbor tests, you'll have to get close to what you owe for the current tax year. That means if your tax liability increases during the year from what you initially expected, you'll have to increase what you're sending to Uncle Sam in order to still be covered. It's possible to make it work, but you will have to stay more on top of it throughout the year.

As Benjamin Franklin famously said, "in this world, nothing is certain except death and taxes."  As you work through wrapping up your 2020 taxes and set yourself up for success in 2021, be sure you make plans to be covered by one of the safe harbor tests. That way, all you'll owe when you settle up is your tax liability, and you'll avoid penalties for not coming close enough throughout the year.