The tax system in the United States can be very complex. Taxes are usually due when income is earned, but these taxes are not always taken out of your earnings automatically. In some cases, you may be required to pay estimated tax on a quarterly basis. An underpayment penalty may be issued by the IRS if a taxpayer fails to pay all taxes due in a timely manner.
5 Things to Know About Underpayment Penalties
- What is an Underpayment Penalty?
- How is the Penalty Calculated?
- How to Avoid an Underpayment Penalty
- Paying Estimated Taxes and Penalties
- Ways to Reduce the Penalty
What is an Underpayment Penalty?
Underpayment Penalties are assessed by the IRS when a taxpayer either does not pay enough income tax or estimated tax for a given period. In some cases, you may be responsible for state and local tax (SALT) underpayment penalties as well. If this is your first time being subject to the underpayment penalty you may be eligible for a waiver. There are also ways to avoid or minimize the penalties that may be due. If you are anticipating owing penalties it may be well worth your time to contact a tax attorney about your specific tax situation and the options available to you.
Earned income that is not subject to tax withholding can include self-employment, business earnings, interest, dividends, rent, and more. If you anticipate owing more than $1,000 in taxes you may be required to file estimated taxes. In comparison, corporations must pay estimated taxes for amounts over $500 per year. These estimated tax payments are due quarterly (not an annual payment) and you can be charged interest on underpaid amounts.
Due to recent tax reform changes in 2018, which impact credits and deductions, your estimated taxes may have changed. You are responsible for knowing about changes and how they impact your tax liability, including changes to estimated taxes due. If you are unsure how this applies to you, it’s important to talk to a tax attorney. For those who may have fallen behind on taxes or are facing a tax levy from the IRS, there are options to help resolve your issues.
How is the Penalty Calculated?
Underpayment penalties are calculated quarterly for amounts due each period. This applies to income earned but tax was not withheld, such as money earned from self-employment, rent, or interest. Those taxes applied to this income are the self-employment taxes (combined tax rate of 15.3%) comprised of Social Security and Medicare taxes and may also include additional Medicare tax or Net Investment Income Tax (NIIT) depending on income sources. The amount left over after deductions and credits may have to be paid using estimated tax methods.
When using estimated taxes to figure the penalties due, you can use the regular income installment method or annualized income installment method. The regular income installment method calculates your total income divided by four equal payments and is used when you receive income in regular amounts. In many cases, however, income is received in uneven and irregular amounts. These situations may require the annualized income installment method. Consult a tax advisor for information on your specific situation to see what method will work best for you.
The payments due each quarter are subject to underpayment penalties if they do not meet the expected amounts. Interest is charged for these penalties based on the amount owed at a 5% rate compounded daily. This rate is based on the federal short-term rate plus 3 percentage points. The IRS determines the rate quarterly and changes in this rate may impact the amount you owe. This is why it is important to regularly review your estimated taxes if any are due. The underpayment penalty is based on the number of days a balance is late multiplied by the effective interest rate for that period. If the effective interest rate changes from quarter to quarter, associated penalties will also fluctuate.
How to Avoid an Underpayment Penalty
Generally, you do not need to pay underpayment penalties if you will owe less than $1,000 in taxes. However, it is worth checking because in some cases a penalty may be charged for not making the correct estimated tax payments. You may also avoid the penalty by making estimated tax payments of at least 90% of the tax for the current year. Alternatively, if you pay income tax withholdings equal to 100% of the total tax from the previous year’s tax return, you can avoid the penalty. For those with higher incomes or adjusted gross income (AGI) over certain amounts, you may be required to pay 110% of the previous tax year. If you are subject to the alternative minimum tax (AMT) you may also need to make estimated payments there as well.
If you determine that you are required to make estimated payments, you must pay the appropriate amounts by each due date or face the penalty calculated each quarter. It is also important to review your state and local taxes for estimated payments due by each period. In addition to the underpayment penalty, you may also face late payments penalties or failure-to-pay penalties which can reach as high as 25% of balances due. Late payment penalties are calculated at 0.5% of past-due amount every month or partial month and failure to file penalties are 5% of each month or partial month. You are usually subject to one or the other but not both of those penalties and only up to that maximum of 25%. Farmers and fishermen face special circumstances regarding estimated taxes. Reach out to Acadia Law Group for more information on how to avoid underpayment penalties. You can also find more information from the IRS Publication 505 Tax Withholding and Estimated Tax.
Paying Estimated Taxes and Penalties
You can use IRS Form 2210 Underpayment of Estimated Tax by Individuals, Estates, and Trusts to determine the underpayment penalty due. The IRS will also determine if a penalty is due and will contact you for the amount. It is important to pay these penalties as the IRS has the power to levy property or right to property including taking from your wages or retirement and bank accounts to satisfy amounts owed.
When to Pay Underpayment Penalties
Estimated taxes are usually due quarterly using the following periods:
- January 01 – March 31
- April 01 – May 31
- June 01 – August 31
- September 01 – December 31
The penalty accrues each quarter at the current daily rate of 5%. If you use the annualized income installment method, you may not be penalized for uneven or irregular estimated tax payments. Remember, even if you may not owe tax, or are under $1,000 in estimated taxes, you may be required to make estimated tax payments or face underpayment penalties. This is in addition to any late payment penalties of or failure to file penalties. You may be interested in the Electronic Federal Tax Payment System or other online payment options to make estimated payments.
Ways to Reduce the Penalty
To reduce the penalty for underpayments, it is important to first pay estimated taxes quarterly. Determine if you must use the regular installment method when you expect regular even payments or annualized income installment method of unequal income amounts to calculate your estimated taxes. If you also work for an employer who pays you wages and withholds tax you may be able to ask them to withhold more in taxes to offset the income from other sources. You can do this by filing a new W-4 with your employer indicating the new withholding amounts desired.
In some cases, the IRS will waive or reduce the penalty. If this is your first time seeing an underpayment penalty due, you may not be required to pay– especially if you did not owe over $1,000 the previous year. It is best to consult with a tax professional to know for sure if this works in your situation. The IRS also may allow waivers for disasters, unusual circumstances, or casualty events. In addition, those retired after 62 or who became disabled during previous or current tax year may also be eligible for a waiver. To be eligible for a waiver, the justification for underpayment must be a reasonable cause and not due to willful neglect. Remember that when calculating your estimated taxes you can use IRS form 2210. It is also possible to use refunds to pay for next year’s estimated taxes. While the IRS doesn’t allow penalties to be deducted, there may be additional ways to reduce the penalties you are facing in your unique situation. Contact the legal advisors of Acadia Law Group for a review of your income tax return.
Taxes can be confusing, especially when factoring in multiple income streams and associated tax regulations. It is always a good idea to consult with legal tax professionals for information about your specific case. Depending on the nature of your earnings, you may be required to pay estimated taxes on a quarterly basis. This is especially important if you earn income that is not subject to tax withholding because tax is due when you earn income. If you do not make these payments or do not pay in full, you may face an underpayment penalty on top of a late payment penalty or failure-to-file penalty.
Underpayment penalties are determined by the IRS quarterly and are based on the federal short-term rate rounded up, plus 3% points, which brings the current underpayment penalty from October 01, 2018 to 5%. This rate may change each quarter and require recalculation of estimated taxes. Your state and city or municipality may also assess underpayment penalties for estimated taxes not paid in full on a quarterly basis. If you expect to owe less than $1,000 in tax after withholding and refundable credits you may not face an underpayment penalty. However, is some cases where you still must pay estimated taxes, you must pay the expected amounts or you might see these penalties even though you don’t owe overall. To avoid underpayment penalties, you can pay at least 90% of estimated taxes for the current year or 100% of the taxes paid in the prior year. For higher income earners you may be required to pay 110% of the previous year’s taxes in order to avoid the penalty.
You can use IRS Form 2210 and IRS Publication 505, along with the IRS Form 1040 and accompanying instructions, to determine your estimated tax requirements and payment periods. For estimated taxes, you can consider the regular income installment method for even income amounts or the annualized income installment method when you experience irregular income amounts throughout the year. An important point to make is that if you also have a job where the employer withholds taxes for you, you may ask them to withhold more each paycheck to satisfy the expected tax due.
In these cases, it would be best to consult with a tax professional in order to ensure that you will not also face an underpayment penalty if enough was not withheld. In addition to these methods, you may also seek waivers or tax relief in certain situations. Be sure to check with a legal tax professional at Acadia Law Group to ensure you are avoiding any potential damage from underpayment penalties and are earning all the deduction and credits you are due.