The U.S. tax system is a "pay-as-you-go" system, which means you must pay your taxes as you receive your income during the year. You do this either through withholding, where your employer withholds taxes from your wages and pays this directly to the government, or by making estimated payments on account of your taxes four times per year. It's important that you pay the full estimated tax and withholding. The reason is the penalty for underpaying is relatively harsh.
What Does Underpayment Mean?
If your employer does not withhold taxes from your paycheck, or you have other income that taxes are not withheld from, then you must make estimated payments on account of your taxes each quarter. The estimated tax payments are due on:
- April 15
- June 15
- Sept. 15
- Jan. 15 of the following year
If the 15th of the month falls on a weekend or public holiday, the payment will be on time if you make it on the next business day. As with most things tax-related, it's up to you to estimate the amount of tax you think you'll be liable for and to make the right amount of estimated payments. If you fail to pay enough tax during the year, either through estimated tax payments or withholding, then you've underpaid. The Internal Revenue Service may hit you with a substantial tax understatement penalty.
What Is the Amount of the Tax Underpayment Penalty?
The underpayment penalty is not a fixed amount, but an interest charge on the amount you underpaid each quarter. The dollar amount is figured separately for each quarterly due date. That's important because it means you can wind up owing more than one penalty. Suppose for example, that you underpaid the installment in April but paid a higher installment in June to make up the underpayment. You may still owe a penalty for underpaying the April installment when it was due. This applies even if you are due a refund when you file your tax return.
The IRS sets the interest rate each quarter. Historically, the rate applied by the IRS has been relatively small, in the region of 3 percent per annum. Rates have been rising recently, however. For individual taxpayers, the interest rate for underpayments was 4 percent for the 2017 tax year and the first quarter of 2018, rising to 5 percent for the remainder of the 2018/2019 tax year.
How Do You Calculate the IRS Underpayment Penalty?
Most times, the IRS will calculate the underpayment for you. When you file your annual tax return, the IRS will perform the following calculations:
1. First, the IRS will calculate how much estimated tax you should have paid each quarter.
2. Second, they subtract the amount already paid in withholding and estimated taxes to figure out the underpayment.
3. Third, they calculate the penalty by applying the interest rate to the outstanding amount owed in each quarter.
4. Fourth, they add the penalty amount for all four quarters together to come up with the total underpayment penalty you owe.
The IRS will then send you a bill specifying the penalty sum that is due. Obviously, you will also be liable to pay the difference between the tax you've already paid and the amount you owe, as well as the underpayment penalty.
Do All Underpaying Taxpayers Face a Penalty Payment?
Fortunately, not all taxpayers will be hit by the underpayment penalty. That's because the IRS has a wide discretion to waive the penalty in certain circumstances. For example, the IRS will never apply the penalty if:
- Your tax liability is less than $1,000 after subtracting your withholding and refundable credits
- You paid at least 90 percent of the taxes owed for the current year through a combination of withholding and estimated payments
- The total of your estimated payments and withholding was at least as much as your total tax liability for the previous year
At the IRS' discretion, you likely will get a penalty waiver if:
- You missed one or more estimated payments because of a disaster, casualty event or other unusual circumstance making it unfair for IRS to impose the penalty
- You became disabled
- Another situation arose where the underpayment was not due to your own negligence or fault.
As you can see, these waivers will take a large number of unintentionally underpaying taxpayers out of the penalty system. Long story short – there's a fair chance you'll avoid the penalty as long as you didn't underpay on purpose.
Can You Reduce the Penalty?
Even if you don't qualify for a waiver, you may be able to get the underpayment penalty reduced in some circumstances. Generally, the IRS expects you to make estimated tax payments in four equal amounts to avoid the penalty. But this requirement may be unfair to some taxpayers whose income is variable or seasonal, and who make most of their income later in the tax year.
Imagine, for example, that you sold off an investment in November 2018, thus triggering a meaty capital gains tax liability. It would be unreasonable to expect you to pay tax installments in the April, June or September of 2018 because you hadn't sold the investment yet. This is the type of situation where the IRS would likely reduce or waive the penalty.
Likewise, if you've recently shifted your tax filing status from single to married filing jointly or vice versa, and all your figures have gotten messed up as a result, the IRS may reduce the penalty. Basically, if anything unusual has happened in the current tax year, it's worth putting a claim in. You may strike lucky.
How Do You Claim a Penalty Waiver or Reduction?
If you've underpaid in a situation where the penalty doesn't apply – for example, your total tax liability is less than $1,000 – you do not need to do anything. The IRS will process your tax return in the usual way. If you've underpaid in a situation where the penalty might apply but feel the penalty should be reduced or waived, for example, because of a disaster, you must file Form 2210. Use this form to calculate the amount of underpayment and its associated penalty, and to explain what caused the underpayment.
For corporations, the comparable form is IRS Form 2220.
How to Avoid Getting Stung With a Penalty
The best way to avoid a penalty is to make sure you pay the correct estimated taxes in the first place. The quickest and easiest method is to look at last year's tax return to find your total liability, subtract any withholding you expect to pay in the current year, and divide the difference by four. This gives you a rough guide to the amount you need to pay through estimated taxes each quarter.
If you expect your income to rise significantly compared to last year, then you'll have to perform a tax calculation based on this year's income. Get ahold of the worksheets found in Publication 505 and with Form 1040-ES. These worksheets include the current year's tax rates and deduction figures to help you calculate the minimum amount of estimated tax you should be paying to avoid a penalty. For a belt-and-braces approach, you might consider overpaying by 10 to 20 percent each quarter. This should provide a nice buffer to help you avoid the penalty.
Finally, if you think you're going to owe more taxes than your employer is withholding, you can file a new W-4 form with your employer. This will increase the amount being withheld to match your required withholding. As long as you've withheld the full amount of taxes by year end, you won't be penalized.
- Internal Revenue Service: Topic Number 306, Penalty for Underpayment of Estimated Tax
- Internal Revenue Service: Publication 505 (2018), Tax Withholding and Estimated Tax
- Investopedia: Underpayment Penalty
- Intuit Proconnect: IRS Federal Underpayment Penalty and Interest Rates
- Internal Revenue Service: Form 2210
- Internal Revenue Service: Form 2220
- Internal Revenue Service: Form 1040 ES
- Internal Revenue Service: IRS Offers New Penalty Relief and Expanded Installment Agreements to Taxpayers Under Expanded Fresh Start Initiative
- Internal Revenue Service: Interest Rates Remain the Same for the Second Quarter of 2012
- LawFirms.com: Penalties for Tax Evasion
- TaxationLawFirms.com: Criminal Tax Evasion
- Nolo: Eliminating Tax Debts in Bankruptcy