IRS Underpayment Penalty – What is it, and how does it work?

An IRS underpayment penalty is a fee levied on taxpayers who fail to make anticipated tax payments or withhold enough money from their income tax liability for the year.

IRS Underpayment Penalty

Individual penalty interest rates have been increased by the IRS to 8% annually. This fine is imposed for underpayment or late payment of any anticipated taxes owed throughout the year, usually by independent contractors or business owners.

Even if you anticipate getting a tax refund, you may still be subject to interest charges by the IRS on the unpaid tax payment as of the day you submit your yearly return. 

Tax underpayment penalties are fines from the IRS for not paying enough taxes via payroll withholdings and quarterly estimated taxes. In late payments, the fee may apply even if the IRS refunds you.

How the IRS Underpayment Penalties Work?

As income is received during the year, taxpayers are required by law to make payments via withholding, paying estimated taxes, or doing both.

  • Individuals whose adjusted gross income (AGI) is $150,000 or less are required to pay 90% of the current year’s tax or 100% of the previous year’s tax by combining estimated and withheld taxes to avoid an underpayment penalty. 
  • The lesser of 90% of the tax owed for the current year or 110% of the tax on the individual’s return for the previous taxable year must be paid by those whose AGI for the previous taxable year exceeded $15,000.

How to Avoid Underpayment Penalties?

The tax underpayment penalty may be avoided in a few fairly easy methods. A few safe harbors are offered by the IRS to taxpayers:

  • Pay the whole amount owed for the prior tax year. Divide the total amount of taxes you owed the previous year by four. Verify that the sum of your projected taxes and any withholdings from taxes from your paycheck equals that amount. You are required to pay 110% of your tax due from the previous year if your adjusted gross income was more than $150,00. On April 15, June 15, September 15, and January 15, estimated tax payments are required.
  • Pay 90% of your tax due for the current year. As long as you complete all of your projected tax payments on time, you will not be subject to the tax underpayment penalty if your withholdings and estimated tax payments exceed 90% of your total tax burden for the year.
  • Less than $1,000 in debt. You will also be released from taxation if all of your timely payments are within $1,000 of your total tax burden.

Not deducting enough from your paycheck is one of the main causes of underpayment. You must therefore make sure that the Form W-4 you complete with your employee is current and appropriately represents your financial situation. 

When the estimated tax penalty doesn’t apply

Fortunately, if certain conditions are met, the IRS will not impose a penalty for underpaying estimated taxes. If, for the whole year, you were either a resident alien or a citizen of the United States, and your previous tax year spanned 12 months, you may be eligible for an exemption from the penalty.

You can potentially be eligible for the safe harbor penalty exemption for anticipated taxes. If you can demonstrate that you had a legitimate reason for missing the payment, that the underpayment was not the result of deliberate carelessness, and:

  • You encounter an unexpected, unusual, or notable event like a calamity casualty or
  • You retired in the previous or current tax year at the age of 62 or older, or
  • Either in the previous or current tax year, you become handicapped.

Who is most likely to pay an underpayment penalty?

There is a chance that several persons may be assessed a tax underpayment penalty.

  • Self-employed persons: All taxes due on a self-employed basis without a W-2 must be paid via quarterly anticipated taxes. Many inexperienced business owners who have never had to pay anticipated taxes may become confused by it.
  • Investors with substantial interest payments, dividends, and capital gains: A significant tax bill may follow a large financial gain. The IRS may charge you a tax underpayment penalty if you fail to pay an additional tax after you learn you have made a gain.
  • Landlords: Taxes must be paid on any income derived from a rental property, and the IRS requires these payments to be made quarterly.
  • Salespeople: Salespeople are generally in charge of making sure the taxes on their commissions are paid in full in addition to producing varying amounts of income.
  • Those who are retired: If you rely on retirement account distributions, you’ll pay taxes on conventional IRA and 401(k) withdrawals. Your custodian may withhold taxes from distributions or you can pay quarterly estimated taxes.

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