Tax underpayment penalty: What it is and how to avoid it (2024)

The IRS expects you to pay taxes on your income throughout the year, either through withholding from your paycheck or estimated quarterly payments.

If you didn’t pay at least 90% of your taxes owed (or 100% of last year’s tax liability) and owe more than $1,000 when you file your taxes, you may be charged a fine called the underpayment penalty.

What is a tax underpayment penalty?

A tax underpayment penalty is a fine the IRS may charge you if you didn’t pay enough taxes on your income throughout the year, or if you paid late.

So, what qualifies as “enough” taxes on your income, and what’s considered on time? The IRS has a rule of thumb you can follow:

“Pay at least 90% of the current year’s tax liability throughout the year or 100% of your prior year’s tax liability, whichever is smaller,” said Shinobu Hindert, a certified financial planner and author of “Investing Is Your Superpower.”

If you have self-employed income, your taxes are due quarterly, and you must submit estimated tax payments directly to the IRS. The penalty is triggered when you don’t pay enough or you don’t pay on time. This may happen even if you get a refund if the quarterly taxes were late.

For example, let’s say you owed $10,000 in taxes throughout the year and should have submitted $2,500 each quarter. If you didn’t submit anything all year and then paid $11,000 on December 29th, you would be due a $1,000 refund. But you could owe penalties for the first three quarters that were not paid on time.

If your employer withholds taxes from your paycheck, they will submit them to the IRS at least monthly. If your employer fails to submit your taxes, they will receive the penalties, not you. However, you can still be charged an underpayment penalty if you don’t have your employer withhold enough taxes via your W-4 form.

How is the penalty calculated?

The underpayment penalty is based on three factors:

• The underpayment amount.
• The period in which you underpaid.
• The underpayment interest rate was 7% for the first, second, and third quarters of the year and 8% for the fourth in 2023.

You can calculate the amount of your penalty by completing the worksheet in the Form 2210 Instructions. Tax software can also help you calculate the number, file the form and pay the penalty. The IRS may also calculate the penalty and send you a bill.

Ways to avoid underpayment penalties

There are several ways to avoid the underpayment penalty in future tax years.

Adjust your withholding

If you receive a paycheck from an employer, you can update the information in your W-4 form, which helps determine how much of your pay is withheld for taxes.

To calculate the right withholding amount, ask a financial professional for help. You can also use the IRS withholding calculator on your own. Once you have the new withholding amount, update your W-4 and submit it to your employer.

Make quarterly estimated payments based on last year’s liability

It’s also possible to send taxes to the IRS by making estimated tax payments. You may need to do this “if your pay varies greatly throughout the year, you’re self-employed or have other sources of income that aren’t subject to immediate withholding,” Hindert said.

Estimated tax payments are due on:

• April 15.
• June 15.
• Sept. 15.
• Jan. 15 of the following year.

If those dates fall on a weekend or holiday, the deadline shifts to the next business day.

You can use Form 1040-ES to estimate your tax liability, or take the total amount of tax you paid last year and divide it into four equal installments. But it’s a good idea to regularly review your quarterly payments to see if you’re on track to pay the minimum tax due.

If you’re earning more this year, received a big raise or a bonus, or started a new job, then “adjust your estimated tax payments or withholding to account for the change,” Hindert said.

Use the annualized installment method to make quarterly payments

Some entrepreneurs have unpredictable income throughout the year, making it difficult to pay estimated taxes in equal installments. One way around this challenge is using the annualized installment method, where your tax payments reflects the income you earned in that quarter.

If you work with an accountant, they can calculate your liability each quarter. If not, you should complete the Annualized Estimated Tax Worksheet found in IRS Publication 505. The worksheet helps you calculate your estimated tax for that quarter. Use the result to make your payments and complete your payment vouchers. You’ll also need to file Form 2210 with your tax return.

How to reduce or eliminate an underpayment penalty

You can avoid the penalty entirely if you owe less than $1,000 or paid enough in taxes throughout the year to meet the IRS minimum (generally, either 90% of the tax owed this year or 100% of what you paid last year).

The IRS may reduce or waive the penalty in some situations. You’ll need to fill out Form 2210, which “will allow you to explain your circ*mstances and ask for a waiver,” said Lawrence Sprung, a certified financial planner and founder of Mitlin Financial. “But completing it does not mean that they will grant the request.”

You may qualify for a waiver if:

1. Most of your tax was withheld early in the year instead of spreading it equally through the year.
2. Your income varies during the year, and this was the cause of the underpayment.
3. You didn’t make a required tax payment because of a casualty event, disaster or another unusual circ*msctance.
4. You’re at least 62 years old or you became disabled during one of the last two tax years, and you had reasonable cause to pay your taxes late.

IRS Form 2210 Instructions can guide you through the process. You may also need to write a statement explaining your situation and include documents to support your claim.

Frequently asked questions (FAQs)