In order to avoid an underpayment penalty, taxpayers must pay at least 100% of last year’s tax or 90% of this year’s tax, or they will be fined by the Internal Revenue Service (IRS). Individuals generally must pay at least 100% of last year’s tax or 90% of this year’s tax to avoid an underpayment penalty.
Here’s how underpayment penalties work and how to avoid them.
Underpayment Penalties: What Are They?
Individuals or corporations may be assessed a tax penalty if they don’t pay enough of their estimated taxes and withholdings due. Taxpayers should consult IRS Form 2210 to see if a penalty must be paid.
What You Need To Know
- When taxpayers fail to pay enough taxes through withholding or estimated payments, or when they pay late, the Internal Revenue Service (IRS) imposes an underpayment penalty.
- A person generally does not have to pay more than 90% of their tax this year if they do not pay 100% of their tax from last year.
- You must pay the lesser of 110% of last year’s tax or 90% of this year’s tax if your adjusted gross income (AGI) for last year exceeded $150,000.
- There is a minimum penalty of 5% and a maximum penalty of 25% for underpayments.
- In addition to interest on unpaid taxes, the IRS also sets an annual rate for underpaid taxes.
Underpayment penalties: How they work
It is the law that taxpayers pay taxes according to the amount of income they receive throughout the year, either with withholding or estimated taxes. Individuals with adjusted gross income (AGI) less than $150,000 must pay 90 percent of the current year’s tax or 100 percent of last year’s tax, combining estimated and withholding taxes, to avoid an underpayment penalty. An individual with an AGI exceeding $150,000 must pay the lesser of 90% or 110% of the taxes due on their return for the previous taxable year if the individual’s AGI is greater than $150,000 in that year.
In the event of underpayment of estimated taxes or uneven payments during the tax year that do not correspond to the taxpayer’s current income, an underpayment penalty may apply. The amount of taxes due should be calculated by considering a taxpayer’s taxable income for Social Security and Medicare.
In some cases, taxpayers may be allowed to pay different amounts quarterly. In some cases, sole proprietors, partners, and shareholders of S corporations must pay tax in four equal payments throughout the year. The IRS Form 2210 can be used by taxpayers to determine whether they have paid enough withholding and estimated taxes during the year to avoid penalties.
The penalty is calculated based on the outstanding amount owed and how long the amount has been overdue. Taxpayers who realize that they have underpaid will have to pay the difference in addition to the penalty. Underpayment penalties aren’t static percentages or flat dollars. They’re calculated based on a variety of factors, including the amount of taxes underpaid and the period during which they were underpaid. Failure-to-pay penalties apply to underpayments, and the penalty is 0.5% on the amount owed for each month and the portion of a month not paid.
It is not allowed for the failure-to-pay penalty to exceed 25% of the unpaid amount.
In addition to a penalty, taxes underpaid (or overpaid) accrue interest. The IRS determines the interest rate every quarter based on the federal short-term rate plus three percentage points.
According to the rates announced on May 30, 2022, the third quarter (Q3) rate will be:
- Individual underpayments are subject to a 5% penalty
- Underpayments by large corporations (greater than $100,000) will be subject to a 7% penalty.
The penalty for underpayment is an example
You would have underpaid your taxes by $3,000 if you owed $5,000 in taxes, but only paid $2,000 for the year.
It is possible to be penalized for underpayment if the amount is more than $1,000 and you do not pay at least 90% of what you owe. The penalty would be the federal short-term rate plus 3 percentage points, so $150.6 would be charged in Q3 2022.
Avoiding Underpayment Penalties
Ensure that you pay your tax obligations on time to avoid an underpayment penalty.
A penalty for underpayment may also be avoided if you meet the following conditions:
- The amount you owe on your tax return is less than $1,000
- Your tax payment is 90% or more of the amount owed for the taxable year, or 100% of the amount owed for the year prior, whichever is less
Other scenarios in which the IRS may waive the underpayment penalty include:
- During the preceding tax year, the taxpayer was a U.S. citizen or resident and did not owe any taxes.
- A casualty event or disaster prevented the taxpayer from making a required payment
- Reasonable cause contributed to the underpayment, not willful neglect
- In the current or preceding tax year, the taxpayer retired at the age of 62
- When the taxpayer has become disabled during the year for which estimated payments are due or during the year prior to the year for which estimated payments are due
Factors to consider
You may qualify for a reduced underpayment penalty in some circumstances if you do not qualify for the exceptions to the underpayment penalty. A person who changes from single to married filing jointly may receive a reduced penalty because the standard deduction is larger.
One example of this is selling an investment holding at the end of the calendar year, triggering significant capital gains taxes.
Is there a penalty for underpayment in 2022?
A large corporation underpaying over $100,000 will be penalized 7%. Underpayment penalties are the federal short-term rate plus 3 percentage points. For the third quarter of 2022, the Internal Revenue Service (IRS) has set underpayment penalties between 5% and 7% for individual underpayments.
How does the IRS define “safe harbor” rules?
Depending on your circumstances, you may be able to avoid an underpayment penalty with the IRS. You would need to owe less than $1,000 or pay more than 90% of your tax obligation per year to avoid an underpayment penalty with the IRS.
Would it be possible to make a single payment of estimated taxes?
The estimated tax payments must be paid quarterly by some taxpayers, such as sole proprietors and partners of S corporations who are expected to owe more than $1,000. These payments cannot be made all at once. They must be paid quarterly.
A penalty may be imposed if you don’t pay enough taxes, whether they are estimated taxes, tax withholdings, or taxes due. To avoid underpayment penalties, make sure you calculate estimated taxes correctly and pay your taxes on time. If you’re charged a penalty, check to see if you qualify for an exemption or reduced penalty.