What It Is, Examples, and How to Avoid One

An underpayment penalty is a effective levied by the Inner Income Service (IRS) on taxpayers who don’t pay sufficient of their estimated taxes, don’t have sufficient withheld from their wages, or pay late. To keep away from an underpayment penalty, people usually should pay at minimal both 100% of final 12 months’s tax or 90% of this 12 months’s tax.

Find out how underpayment penalties work and extra about how one can keep away from them.

What Is an Underpayment Penalty?

A tax penalty is imposed on particular person or company taxpayers for not paying sufficient of their whole estimated tax and withholding due. Taxpayers ought to seek the advice of IRS Kind 2210 to find out if they’re required to report an underpayment and pay a penalty.

How Underpayment Penalties Work

The tax regulation requires that taxpayers make funds as they understand revenue all year long by way of withholding, estimated taxes, or each. To keep away from an underpayment penalty, people whose adjusted gross revenue (AGI) is $150,000 or much less should pay the lesser of 90% of the present 12 months’s tax or 100% of final 12 months’s tax, by combining estimated and withholding taxes. People whose AGI for the previous taxable 12 months exceeds $150,000 should pay the lesser of 90% of the tax due for the present 12 months tax or 110% of the tax on the person’s return for the prior taxable 12 months.

The underpayment penalty is owed when a taxpayer underpays the estimated taxes or makes uneven funds in the course of the tax 12 months that don’t correspond adequately to the taxpayer’s present revenue for a interval. Taxpayers with self-employment revenue ought to take their legal responsibility for Social Safety and Medicare taxes into consideration when calculating the quantities due.

Some taxpayers, similar to sole proprietors, companions, and S company shareholders, should pay taxes in 4 equal funds in the course of the 12 months. In some instances, taxpayers who obtain their revenue erratically could possibly pay completely different quantities quarterly. Taxpayers ought to use IRS Kind 2210 to find out if their funds of withholding and estimated taxes in the course of the 12 months are enough to keep away from a penalty.

If taxpayers understand that they’ve underpaid, they have to pay the distinction—plus a penalty that’s calculated primarily based on the excellent quantity owed and the way lengthy the quantity has been overdue. The penalty will not be a static proportion or flat greenback quantity. It’s primarily based on a number of issues, together with the full underpayment quantity and the interval by which taxes have been underpaid. Underpayments are topic to the failure-to-pay penalty, which is 0.5% of the quantity owed for every month and the a part of a month for which the tax will not be paid.

Curiosity Funds

Together with a penalty, tax underpayments (or overpayments) accrue curiosity. The IRS determines the rate of interest each quarter, usually basing it on the federal short-term charge, plus 3 proportion factors, for many particular person taxpayers.

For the third quarter (Q3) of 2022, the charges (introduced on Might 30, 2022) are:

• 5% for particular person underpayments
• 7% for big company underpayments (exceeding $100,000)

Instance of Underpayment Penalty

For instance, in case you owed $5,000 in taxes for the 12 months, however solely paid $2,000, you’ll have underpaid your taxes by $3,000.

As a result of the quantity is greater than $1,000 and also you didn’t pay no less than 90% of what you owed, you’ll be topic to an underpayment penalty (until you met different standards for avoiding it). The penalty could be the federal short-term charge plus 3 proportion factors. For Q3 2022, that charge could be 5%, or $150.

Keep away from Underpayment Penalty

One of the simplest ways to keep away from an underpayment penalty is to take steps to make sure that your tax obligations are totally paid on time.

You can too keep away from the underpayment penalty if:

• Your tax return exhibits you owe lower than $1,000
• You paid 90% or extra of the tax that you just owed for the taxable 12 months or 100% of the tax that you just owed for the 12 months prior, whichever quantity is much less

The underpayment penalty can also be waived by the IRS beneath a number of different eventualities, together with:

• The taxpayer was a U.S. citizen or resident for the previous tax 12 months and didn’t owe any taxes for that 12 months
• The taxpayer missed a required fee due to a casualty occasion, catastrophe, or different uncommon circumstance
• The underpayment was a results of affordable trigger and never willful neglect
• The taxpayer retired after reaching age 62 in the course of the present or previous tax 12 months
• The taxpayer turned disabled in the course of the tax 12 months for which estimated funds have been owed or in the course of the previous tax 12 months

Particular Issues

If you don’t qualify for the exceptions to the underpayment penalty, it’s possible you’ll qualify for a diminished underpayment penalty in some conditions. For instance, a person who modifications their tax submitting standing from single to married submitting collectively could get a diminished penalty because of the bigger customary deduction.

A discount may also be prolonged to taxpayers who generate important parts of their revenue late within the calendar 12 months. One such instance is an funding holding that’s bought in December, triggering a considerable capital positive factors tax.

The Backside Line

In case you do not pay sufficient taxes—estimated taxes, tax withholding, or taxes due—you would find yourself paying an underpayment penalty. In case you’re charged a penalty, examine to see in case you qualify for an exemption or diminished penalty. However the easiest way to keep away from underpayment penalties is to ensure that you work estimated taxes accurately and pay your taxes on time.