What Is Tax Underpayment Penalty?

So, here are two truths: Everyone is accountable for taxes based on their income. Whether you are a freelancer or a paid employee (as long as you earn more than the standard deduction for your tax-filing status). And nobody enjoys owing Uncle Sam on tax day for fear of the tax underpayment penalty.

Employers routinely withhold taxes from the paychecks of salaried and hourly employees or those who receive a W-2. The self-employed receive 1099 or send invoices from customers/clients to estimate quarterly tax payments.

However, there are situations when you may not have paid enough in taxes and only realize it when it is too late by the tax filing season. Underpaying your overall tax during the year can result in a significant bill at tax-filing time and the IRS’s tax underpayment penalty.

What Is The Underpayment Penalty?

The tax underpayment penalty is a fine that the IRS imposes on taxpayers who fail to pay enough tax through withholdings or scheduled payments during the tax year. The IRS applies various penalties to encourage taxpayers to follow IRS guidelines and deter intending defaulters.

An underpayment penalty may apply if:

  • The amount you paid for tax during the tax year was less than 90% of the tax due for the new year.
  • You didn’t pay at least 100 percent of the taxes you owed the previous year.

For example, you may be subject to an underpayment penalty if you are supposed to pay a federal income tax of $10,000 for the current year, but you only paid $8,000 (or less than 80% of your entire tax liability).

The silver lining is that the IRS says that if the amount you owe after subtracting withholdings and refundable credits is less than $1,000, you may avoid the penalty.

But if you are subject to a penalty, you may have to file IRS Form 2210. The IRS will usually compute the underpayment penalty for you, but you may have to calculate the liability yourself in some cases.

How Do Tax Underpayment Penalties Work?

When a taxpayer underpays estimated taxes or makes inconsistent payments during the tax year, they get the tax underpayment penalty. You can calculate the amount of taxes payable with IRS Form 2210, the amount already paid in anticipated taxes throughout the year.

As a taxpayer who has discovered that you have underpaid, you must pay the difference plus a penalty based on the amount owed and the length of time the amount has been past due.

The penalty isn’t based on a fixed percentage or monetary amount. It is dependent on several factors, including the overall amount of underpayment and the time during which you underpaid taxes.

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Underpayments that depend on the failure-to-pay penalty are 0.5 percent of the amount owed for each month or the part of a month you owe.

How Can We Calculate The Tax Underpayment Penalty?

We calculate the amount of the Underpayment of Estimated Tax by Individuals Penalty based on the tax

You can calculate the Underpayment of Estimated Tax by Individuals Penalty using the tax stated on your original return or a more recent return submitted on or before the due date. Your total tax minus your total refundable credits is the tax displayed on your return.

Your underpayment payment depends on the following criteria:

  • How much you owe as the underpayment
  • The time frame during which you owed, and it was unpaid
  • The interest rate for underpayments

What Are Interest Payments?

Tax underpayments (and overpayments) carry interest in addition to a penalty. The IRS sets the interest rate every quarter for most individual taxpayers based on the federal short-term rate plus three percentage points.

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Underpayment Penalty Example

Let’s say you underestimated your quarterly taxes or claimed too many deductions on your W-4, resulting in an underpayment of taxes for the year.

You can first submit a new W-4 to your employer with fewer deductions, so you cover your tax liability for the following year. Meanwhile, for someone who files estimated quarterly payments, here’s what happens when you underpay taxes.

Assuming that you made the following quarterly payments:

  • April 15: $2,000 (the complete estimated tax due)
  • June 15: $2,000 (complete estimated tax due)
  • September 15: $2,000 (complete tax)
  • January 18 of the following year: $500 (estimated tax due of $2,000)

So, now you owe $1,500 in underpaid taxes.

There are two options:

You may choose to wait for the IRS to send you a letter specifying the amount of the underpayment after you file your taxes. But, you should note that the interest payable began accruing on January 18, when the taxes were due.

So, the interest you will owe will increase if you wait another month for a letter from the IRS. It may be the most surefire technique to meet your tax obligation if the underpayment is only a small amount. However, if your underpayment is severe, an additional 3% in penalties could be substantial.

You may also decide to compute the expected underpayment penalty and pay it as soon as possible. If you choose this option, your accountant will use Form 2210 to calculate the penalty amount.

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Your accountant calculates the federal short-term rate for the quarter, which is 14 percent in January and adds three percent to the rate.

Because you underpaid $1,500, you must submit a tax payment of $1,547.10, which includes the amount owed plus 3.14 percent as a tax underpayment penalty.

Are There Exceptions For Tax Underpayment Penalties?

There are no penalties on all underpaying taxpayers. It may be waived in a variety of circumstances, including:

  • A taxpayer’s total tax liability is not up to $1,000
  • The taxpayer did not owe any taxes the previous year
  • If you paid at least 90% of the taxes owed
  • If you missed a required payment due to a casualty event, disaster, or other unusual circumstance
  • The taxpayer retired after reaching the age of 62
  • The taxpayer became disabled during the tax year or during the preceding tax year for which estimated payments were not made

There are also particular scenarios

These considerations could qualify you for a reduced underpayment penalty in some situations. For example, an individual who changes their tax filing status from single to married filing jointly may be eligible for a lower penalty.

Or taxpayers who earn a significant amount of their income late in the calendar year may be eligible for a discount. A practical example is a December sale of an investment holding.

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How Do I Avoid An Underpayment Penalty?

The most straightforward approach to avoid an underpayment penalty is to pay at least 100% of last year’s tax. But if you have been penalized before and do not want a repeat, you can:

#1. Adjust Your Withholding

Consider filling out a new Form W-4, Employee’s Withholding Certificate, if you get a paycheck from your employer. This document informs your employer of the amount of tax to deduct from your paycheck each month. If your employer has not been subtracting enough, you can update your W-4 and ask that they take out more.  

You can use the IRS’s Tax Withholding Estimator to determine how much your employer withholds from your paycheck for the federal income tax. Don’t send the new Form W-4 to the IRS; instead, provide it to your company’s payroll department.

#2. Make Estimated Quarterly Payments

You must make scheduled payments throughout the year if you are self-employed or have considerable income that isn’t subject to withholding, such as interest, dividends, and capital gains.

Estimated payments are due on the following dates: April 15, June 15, September 15, and January 15 of the next year.

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The deadline is often moved to the next working day if any of those days fall on a weekend or holiday. Remember those deadlines because, even if you don’t owe any additional tax when you file your return, failing to make your projected payments on time can result in an underpayment penalty.

To avoid a penalty, divide the total tax on your prior-year return by four and pay at least that amount on each estimated tax due date.

#3. Make Use Of The Method Of Annualized Installments.

Making four equal projected payments can be challenging if you’re self-employed or run a seasonal business. Or if perhaps you earn most of your revenue mid-year.

You may consider employing the annualized income installment approach to avoid an underpayment penalty may be beneficial.

Here, you would calculate your required payment using the Annualized Estimated Tax Worksheet contained in IRS Publication 505 at the end of each estimated tax payment period. Along with your tax return, you’ll need to file Form 2210, including Schedule AI.

FAQ’s

How Do I Avoid An Underpayment Penalty?

#1. Adjust Your Withholding

#2. Make Estimated Quarterly Payments

#3. Make Use Of The Method Of Annualized Installments.

How Can I Calculate The Tax Underpayment Penalty?

  • How much you owe as the underpayment
  • The time frame during which you owed, and it was unpaid
  • The interest rate for underpayments

When may an underpayment penalty apply?

  • If the amount you paid for tax during the tax year was less than 90% of the tax due for the new year.
  • When you didn’t pay at least 100 percent of the taxes you owed the previous year.

Bottom Line

So, yes, the IRS may levy a fine if you do not pay a significant amount of your taxes owed throughout the year.

And if you still owe the tax underpayment penalty, you can ask for a waiver if you can establish that you had a valid excuse or that you were unable to compute your expected income.

But you must ensure you avoid the penalty in the future by paying the IRS the correct amount throughout the year.

If you’re self-employed, you can ask your employer to withdraw more from your salary or add more to your quarterly estimated tax payments.

References

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