If you’re required to pay estimated tax payments, the IRS could charge you with an underpayment penalty if you pay too little, too late, or don’t have enough withheld from your wages. Accurately estimating your quarterly tax payments can be difficult, but in order to avoid getting fined, you’re required to pay at least 100% of your previous year’s tax liabilities or 90% of this year’s taxes.
This article will explain who is at risk of underpayment penalties, how much you could be fined, and how to avoid it.
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What is an underpayment penalty?
The US tax system operates on a pay-as-you-go basis. Rather than paying a lump sum all at once, you’re obligated to pay taxes as you earn or receive income during the year.
- If you receive a W-2 income, your employer will withhold your federal and state taxes from your paycheck and pay them on your behalf throughout the year.
- If you’re self-employed, you’ll be required to pay estimated tax payments. These are due four times each year, typically on April 15, June 15, September 15, and January 15, unless the day falls on a weekend or holiday it would be moved to the following weekday.
An underpayment penalty is a fine on individual or corporate tax payers who don’t pay enough of their quarterly estimated taxes, don’t have enough money withheld by their employer, or pay their estimated taxes too late.
How much in penalties will I have to pay?
The amount of the underpayment penalty is not a static amount, and is calculated using the amount you owe, how long you haven’t paid, and .
You’ll typically be charged with interest at the federal short-term borrowing rate in addition to an extra 3 percentage points onto the annual percentage rate for the penalty. You and your accountant can use Form 2210 to determine the exact penalty amount.
Additionally, underpayments can also be subject to the failure-to-pay penalty, which is 0.5% of the amount owed for each month that you haven’t paid, up to a maximum of 25%.
Who is at risk of underpayment penalties?
Anyone who is required to pay estimated taxes can be fined with the underpayment penalty.
You’re required to pay estimated tax payments if:
- You expect to owe at least $1,000 in taxes, after subtracting your withholding and tax credits, when you file your return.
- You expect your withholding and tax credits to be less than the smaller of: 90% of the tax to be shown on your tax return, or 100% (110% if your 2023 AGI is over $150,000) of the tax shown on your 2022 tax return (must cover all 12 months of the 2022 tax year).
- You earn a W-2 income but not enough taxes are being withheld by your employer.
- You run a business or are part of a corporation, partnership, or LLC.
- You generated capital gains or received dividend income on your investments.
- You generated rental income from your properties.
- You received royalty payments.
Estimated tax payments are most commonly made by self-employed individuals, business owners, freelancers, investors, landlords, and corporations.
Exceptions
Even if you fall into the categories listed above, you’re not required to pay estimated tax payments if your estimated tax liability for the tax year is under $1,000.
Additionally, you are not required to pay if you meet all three of these conditions:
- You had no tax liability for the previous tax year, meaning your total tax was zero or you didn’t have to file a return.
- You were a US citizen or resident alien for the whole current tax year.
- Your previous tax year covered a 12 month period.
How to avoid underpayment penalties
There are two ways to avoid being fined with an underpayment penalty:
- Pay at least 90% of your current tax year’s tax liability with timely quarterly estimated tax payments. The best way to avoid the underpayment penalty is to estimate your taxes owed by a tax professional, using software, or using Form 1040-ES to estimate your taxes owed to ensure you pay at least 90% of your taxes owed for the current year.
- Pay at least the equivalent amount of 100% of the taxes owed from last year’s federal tax return. The IRS has a safe harbor rule for estimated tax payments as well. Even if your income grew this year, you can generally avoid the penalty by paying 100% of the taxes you owed on last year’s federal tax return. If your adjusted gross income is over $150,000, then you’re required to pay 110% of the taxes owed from last year’s return.
How will I know if I receive an underpayment penalty?
The IRS will send you a notice stating you owe the Underpayment of Estimated Tax by Individuals Penalty.
How to dispute an underpayment penalty
If you received an underpayment penalty, the penalty can be waived or reduced for the following reasons:
- You retired after reaching age 62 or became disabled either in the current or previous tax year, and your underpayment was due to reasonable cause (not willful neglect).
- The underpayment was due to a casualty, disaster, or other unusual circumstance like serious illness or injury, a family member’s death, or similar situations beyond your control.
If you do not meet the conditions outlined above, you can only dispute an underpayment penalty if the penalty was imposed after you relied on incorrect advice that the IRS gave you.
- The written advice the IRS gave you was in direct response to your written request for advice
- The incorrect written advice the IRS gave you was not the result of material omissions or misinformation in your written request for advice
- You reasonably relied on the IRS written advice and were penalized based on that advice