The tax system in the United States can be very complex. Taxes generally must be paid when income is earned, but these taxes are not always automatically removed from your earnings. In some cases, you may have to pay estimated taxes quarterly. The IRS may issue an underpayment penalty if a taxpayer fails to pay all taxes due in a timely manner.
5 things you should know about underpayment penalties
- What is an underpayment penalty?
- How is the penalty calculated?
- How to avoid an underpayment penalty
- Payment of estimated taxes and penalties
- Ways to Reduce Grief
What is an underpayment penalty?
Underpayment penalties are imposed by the IRS when a taxpayer fails to pay enough income tax or estimated tax for a given period. In some cases, you may also be responsible for penalties for underpayment of state and local taxes (SALT). If this is the first time you are subject to the underpayment penalty, you may be eligible for an exemption. There are also ways to avoid or minimize the penalties that may be due. If you are anticipating the payment of fines, it may be worth spending your time contacting a tax attorney about your specific tax situation and the options available to you.
Earned income that isn’t subject to tax withholding may include self-employment, business earnings, interest, dividends, rent, and more. If you anticipate that you owe more than $ 1,000 in taxes, you may be required to file estimated taxes. In comparison, corporations must pay estimated taxes in amounts greater than $ 500 per year. These estimated tax payments are due quarterly (not an annual payment) and you may be charged interest on underpaid amounts.
Due to recent changes in tax reform in 2018, affecting credits and deductions, your estimated taxes may have changed. You are responsible for knowing the changes and how they affect your tax liability, including changes in estimated tax due. If you are not sure how this applies, it is important to speak to a tax attorney. For those who may have fallen behind on taxes or face IRS tax, there are options to help you solve your problems.
How is the penalty calculated?
Penalties for underpayment are calculated quarterly for amounts due in each period. This applies to income earned but no tax withheld, such as money earned from self-employment, rent, or interest. Taxes applied to this income are self-employment taxes (15.3% combined tax rate) comprising Social Security and Medicare taxes and may also include additional Medicare tax or Net Investment Income Tax (NIIT) according to income sources. The remaining amount after deductions and credits may have to be paid using estimated tax methods.
When you use estimated taxes to calculate the fines owed, you can use either the regular payment method of payments or the annualized income payment 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 payment method. Consult a tax advisor for information on your specific situation to see which method will work best for you.
Payments due quarterly are subject to underpayment penalties if they do not meet expected amounts. Interest is charged on these fines based on the amount due at a rate of 5% 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 can affect the amount you owe. This is why it is important to regularly review your estimated taxes if necessary. The underpayment penalty is based on the number of days the balance is past due and multiplied by the effective interest rate for that period. If the effective interest rate changes from quarter to quarter, the associated penalties will also fluctuate.
How to avoid an underpayment penalty
You generally don’t have to pay a penalty if you owe less than $ 1,000 in taxes. However, it is worth checking because in some cases a fine may be charged for not making the correct estimated tax payments. You can 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 income or adjusted gross income (AGI) on certain amounts, you may have to pay 110% of the previous fiscal year. If you’re subject to Alternative Minimum Tax (AMT), you may also need to make the estimated payments there.
If you determine that you are required to make estimated payments, you must pay the appropriate amounts on each due date or face the calculated penalty each quarter. It is also important to review state and local taxes for the estimated payments you must make in each period. In addition to the underpayment penalty, you may also face late payment penalties or late payment penalties that can reach up to 25% of the balances due. Penalties for late payments are calculated at 0.5% of the amount due each month or partial month and the failure to file fines is 5% of each month or partial month. Generally, it is subject to one or the other, but not to both fines and only up to that maximum of 25%. Farmers and fishermen face special circumstances regarding estimated taxes.
Payment of estimated taxes and penalties
You can use the IRS Form 2210 for underpayment of estimated tax by individuals, states, and trusts to determine the underpayment penalty. The IRS will also determine if a fine is owed and will contact you for the amount. It is important to pay these fines, as the IRS has the power to impose a property or the right to property, including the payment of your salary or your retirement and the bank accounts to satisfy the amounts owed.
When to pay penalties for underpayment
Estimated taxes are generally due quarterly using the following periods:
- January 1 – March 31
- April 1 – May 31
- June 1 – August 31
- September 1 – December 31
The penalty accumulates each quarter at the current daily rate of 5%. If you use the annualized income payment method, you cannot be penalized for non-uniform or irregular tax payments. Remember, even if you cannot owe taxes, or have less than $ 1,000 in estimated taxes, you may be required to make estimated tax payments or face penalties for underpayment. This is in addition to any fine for late payment or failure to file penalties. You may be interested in the Electronic Federal Tax Payment System or other online payment options for making estimated payments.