Penalty for Underpaying Estimated Taxes

As you earn, the IRS requires you to pay estimated taxes throughout the year, either by withholding from paychecks or by making quarterly estimated payments. If you underpay throughout the year, the IRS imposes an underpayment penalty. 

When a taxpayer underpays estimated taxes or makes inconsistent payments during the tax year that do not correlate with their income, the IRS imposes an underpayment penalty. This penalty applies to individuals, estates, and trusts that do not pay enough estimated tax on their income or pay it late. 

If taxpayers discover that they have underpaid, they must pay the difference, plus a penalty based on the outstanding amount owed and the length of time the money has been overdue. To help you understand this penalty, this post outlines the basics. To get help now, contact us today.

How Much Is the Penalty for Underpaying Estimated Taxes?

The underpayment penalty is not a fixed percentage or monetary amount. It is based on numerous factors, including the total amount of underpayment and the time period during which taxes were not paid. Underpayments are also subject to a failure-to-pay penalty of 0.5% of the amount owed for each month and part of a month in which the tax is not paid. 

However, the IRS does take into consideration that knowing how much tax you owe can be difficult, especially if your income and deductions change from year to year. Because of this, the IRS offers a ‘safe harbor’ method. 

Safe Harbor Method

With the safe harbor method, the IRS will not charge an underpayment penalty if:

• You pay at least 90% of your current-year tax liability, or 100% of your previous-year tax liability, or
• After deducting withholdings and credits, your tax liability is less than $1,000.

It’s important to note, however, that this rule is slightly modified for high-income taxpayers. If your AGI on your previous year’s return was more than $150,000 for a couple filing jointly (or $75,000 if married filing separately), you must pay at least 90% of the tax reported on the current year’s return or 110% of the tax shown on the previous year’s return.

How to Calculate the Underpayment Penalty

The underpayment penalty is difficult to calculate because, unlike other IRS penalties, it is not a fixed percentage or monetary amount. Instead, it depends on:

• Your total underpayment amount. 
• The quarter in which you underpaid. 
• The IRS’s quarterly underpayment interest rate.

To calculate your penalty, you can use Form 2210. This form guides you through the process of calculating your penalty. 

Do You Have to File Form 2210?

You don’t necessarily need to file Form 2210. If you didn’t withhold enough tax by the end of the year, you will pay the penalty when you file your tax return. Your accountant can calculate the penalty for you, and most tax prep software will also automatically calculate the penalty. Otherwise, the IRS will calculate the penalty after you file, and they will send you a notice.

You only need to file Form 2210 if the following apply:

• You want to request a full penalty waiver – In this case, you only need to fill out the first page of the form. You don’t need to work through the pages with the calculations.
• You want to request a partial penalty waiver – Then, you must complete the full form with all of the penalty calculations. 
• Your income varied throughout the year – Normally, the IRS calculates your tax due as if you earn the same amount every quarter of the year. You can use this form to get a more accurate calculation based on your actual income flow.
• You want credit for taxes that were withheld or paid during the year – Normally, the IRS calculates the payments in equal amounts on the due dates, but you can use this form to ensure the calculations reflect the exact day of your tax payments. 
• You’re filing a joint return for one year and a separate or single return for another year – If changes in your filing status affect your penalty calculation, you can use this form to make sure you get the lowest penalty possible. 

Interest on Underpayment Penalties

Tax underpayments incur interest in addition to a penalty. The IRS sets the interest rate for most individual taxpayers every quarter, based on the federal short-term rate plus 3 percentage points.

The interest rates for the fourth quarter (Q4) of 2022 were:

• 6% for individual underpayments
• 8% for substantial corporate underpayments (above $100,000)

The rates for the first quarter of 2023 are 7% for individual underpayments and 9% for large corporate underpayments.

For example, if you owe $5,000 in taxes for the year but only paid $2,000, you would have paid $3,000 less in taxes. Because the underpayment is greater than $1,000, and you did not pay at least 90% of what you owed, you would be subject to an underpayment penalty. 

The penalty would be equal to the federal short-term interest rate plus three percentage points. The interest starts accruing the day your payments should be due. To continue with the above example, say that you paid $500 every quarter in estimated payments, but based on your $5,000 tax liability, the IRS thinks that you should have paid $1,250 every quarter. 

During the first quarter, you underpaid by $750, so that amount starts occurring interest as of the due date for first quarter payments. Then, the following quarter, you also underpaid $750. This amount starts accruing interest on the second quarter’s due date. This pattern continues throughout the year. 

Another example, say a corporation was supposed to pay $120,000 in estimated quarterly taxes, but it didn’t make a payment. Because this is a substantial underpayment, the IRS applies interest at a higher rate. Again, the rate was 8% for substantial corporate underpayments in Q4 2022. 

The date on which the IRS begins charging interest varies depending on the type of penalty. Interest raises the amount owed until the balance is paid in full.

What to Do If You Can’t Pay in Full

If you are unable to pay your taxes in full on time, you can apply for a payment plan. To settle the remaining payment, you can enter into an Instalment Agreement. However, on any amount not paid, including penalties and interest, interest will continue to accrue daily.

The best method to avoid an underpayment penalty is to guarantee that all of your tax obligations are paid on time. You can also avoid the underpayment penalty if you owe less than $1,000 on your tax return, you paid 90% or more of the tax you are owing for the taxable year or 100% of the tax you owed the previous year. 

Penalty Waivers

If you or your spouse retired or became handicapped within the last two years, reached the retirement age of 62, and/or had justifiable cause to pay your estimated taxes late, you may be able to ask the IRS to waive or decrease your underpayment penalty. You can also get penalty abatement for reasonable cause.

A “reasonable cause” could be a house fire or natural disaster, the death or serious illness of an immediate family member, or another unforeseen circumstance that prevented you from making your estimated payments on time. 

Another reason for a waiver is if you had the majority of your income withheld early in the year rather than spreading it evenly throughout the year. The IRS may also waive the underpayment penalty if the taxpayer was a U.S. citizen or resident for the preceding tax year and did not owe any taxes for that year. 

If any of the above situations apply to you, you can contact the IRS at the toll-free number on your penalty notice or complete Form 843 to request a waiver. 

How to Avoid Underpayment Penalties

If you owe a penalty on your current tax return and wish to avoid the same problem in the future, consider filling out a new Form W-4 (Employee’s Withholding Certificate) if you get a paycheck from your employer. This document instructs your employer on how much tax to deduct from your pay each period. You can use the IRS’s Tax Withholding Estimator to determine how much federal income tax to have withheld from your paycheck. Do not mail the new Form W-4 to the IRS; instead, provide it to your company’s payroll department.

If you are self-employed or have considerable income that is not subject to withholding, such as interest, dividends, and capital gains, you must make estimated payments throughout the year. Estimated payments are due on April 15, June 15, September 15, and January 15 of the following year. If any of those dates fall on a weekend or holiday, the deadline is moved to the next working day. Pay particular attention to those deadlines since failing to make your estimated payments on time might result in an underpayment penalty, even if you don’t owe any additional tax when you submit your return.

Estimated Payments When Your Income Varies

Making four equal estimated payments can be challenging if you are self-employed with variable income or own a seasonal business. In that instance, employing the annualized income installment method can help you in avoiding a penalty for underpayment. To utilize this technique, at the end of each estimated tax payment period, complete the Annualized Estimated Tax Worksheet available in IRS Publication 505 to calculate your required payment. Form 2210, containing Schedule AI, must also be included with your tax return.

You are not required to pay anything until you have earnings on which estimated taxes are due. If you know you’ll have to make estimated payments early in the year, each of the four installments should be 25% of the total amount due.

But what if you earn income in the third quarter that makes you liable for estimated tax payments for the first time? Your first payment is due on the third installment date, September 15, and you are required to pay 75% of the tax owed. You must utilize IRS Form 2210 to demonstrate that your estimated tax payment is due because of income earned during a specified time of year. If you do not, the IRS assumes you received the income all year and simply underpaid your estimated tax. This could result in a penalty.

To keep your payments to a minimum, base each installment on what you must pay to avoid the penalty and take use of any exceptions that apply to you.

Special Rules for Farmers and Fishers

Qualifying farmers and fishermen must pay only two-thirds (66.67%) of their tax, or 100% of the tax reported on their previous year’s tax return, whichever is less. Generally, people in these professions won’t get a penalty as long as they pay their tax liability by January 15th or the 15th day following the end of their tax year if they use a non-fiscal year.

Individuals, estates, and trusts with at least two-thirds of their gross yearly income from farming or fishing are eligible to file Form 2210-F, Underpayment of Estimated Tax by Farmers and Fishermen, to determine if you owe a penalty for underpayment of estimated tax. 

Get Help With Estimated Tax Penalties

If you do not pay enough taxes—estimated taxes, withholding taxes, or taxes due—you may be subject to an underpayment penalty. If you are charged a penalty, examine if you are eligible for an exemption or a reduced penalty. However, the easiest method to avoid underpayment penalties is to ensure that you correctly calculate estimated taxes and pay your taxes on time.

Need help? If you are overwhelmed by calculating estimated taxes, or the underpayment penalty, call the qualified team at the W Tax Group. We’ll start with a free consultation and provide you with the answers you need. Call 877-500-4930 or fill out the online contact form for help.

Lead Tax Attorney at The W Tax Group

Stephen A Weisberg