Underpayment penalties are a common concern for taxpayers, and many are unaware of how substantial they can be. These penalties are assessed by the Internal Revenue Service (IRS) when taxpayers fail to pay enough of their tax liability through withholding or estimated tax payments throughout the tax year. The interest rate for underpayments has been 8% per year, compounded daily, since October 1, 2023 and at least through June 30, 2024. That is up from 3% just two or three years ago.
Understanding underpayment penalties and the strategies to avoid them can save you from unnecessary financial stress and penalties. This article will delve into the intricacies of underpayment penalties and offer guidance on how to navigate these waters effectively.
Understanding Underpayment Penalties - Underpayment penalties are essentially the IRS's way of ensuring that taxpayers are paying their taxes on a quarterly basis rather than waiting until the tax filing deadline. The IRS requires that you pay at least 90% of your current year's tax liability or 100% of the tax shown on your return for the previous year (110% if you're considered a higher-income taxpayer) throughout the year. If you fail to meet these thresholds, you may be subject to the underpayment penalty. Think of it this way: the IRS is effectively charging you interest on the tax money you kept instead of sending it to the government.
The penalty is calculated on a quarterly basis, meaning that if you underpaid in any given quarter, you might be penalized for that quarter even if you overpaid in another. The rate of the penalty is determined by the IRS and can vary from quarter to quarter. For self-employed individuals or those without sufficient withholding, estimated tax payments are a critical tool in managing tax liability and avoiding underpayment penalties. You would think that a quarter of the year would be 3 months, but for the purpose of this calculation, the “quarters” are uneven and cover January – March (3 months), April and May (2 months), June, July and August (3 months) and finally the last 4 months of the year.
De Minimis Exception - The de minimis exception is one way to avoid underpayment penalties. If your total tax liability minus your withholdings and tax credits is less than $1,000, you won't be subject to underpayment penalties. This rule is particularly beneficial for taxpayers who have a relatively small tax liability.
Safe Harbor Payments - Safe harbor payments are essentially benchmarks set by the IRS that, if met, protect taxpayers from underpayment penalties, regardless of their actual tax liability for the year. These benchmarks are designed to ensure that taxpayers pre-pay a minimum amount of their tax obligation throughout the year, either through withholding or estimated tax payments.
The general rule for safe harbor payments requires taxpayers to prepay the lesser of 90% of the current year's tax or 100% of the previous year's tax. However, for those with an adjusted gross income (AGI) over $150,000 ($75,000 if married filing separately), the rules tighten. These individuals must pay the lesser of 90% of the current year's tax or 110% of the previous year's tax to qualify for this safe harbor. Thus, the safe harbor that works for any eventuality is 110% of the previous year's tax liability. In addition, if you had no tax liability in the prior year, then you are exempt from an underpayment penalty.
Since these pre-payments consist of both withholding and estimated tax payments, the timing of these payments is also critical for payments to qualify for the safe harbor penalty exception. Estimated tax payments are due in four installments: April 15, June 15, September 15, and January 15 of the following year, approximately 2 weeks after the end of the “quarters” noted above. If any of these dates falls on a Saturday, Sunday, or legal holiday, the due date will be the next business day. Caution: Some states have different estimated payments dates and, in some cases, amounts for state estimated payments.
Withholding - Unlike estimated payments, withholding is considered paid evenly throughout the year, regardless of when it occurs. This can be particularly useful for taxpayers who realize they may fall short of their safe harbor requirements as the year progresses and boost their withholding by one means or another depending upon the increase required.
An employee can increase their withholding for the balance of the year by providing their employer with a modified W-4 form that will cause the employer to increase withholding for the balance of the year.
Where the increased withholding need is discovered closer to the end of the year, a cooperative employer might be willing to withhold a lump sum amount.
10% is the default withholding rate for nonperiodic withdrawals from traditional IRA accounts when you fail to provide a Form W-4R to the payer that indicates your desired withholding rate (0% - 100%). Thus by submitting a Form W-4R, or a revised one, to the payer of the IRA, requesting a higher withholding rate, additional withholding can be achieved. Where you are not employed (or even if you are), you can create more tax withholding by taking a distribution and then rolling the distribution amount back into the traditional IRA or a qualified retirement plan within the statutory 60-day time frame. To achieve this strategy you will need to make up for the withholding with other funds when making the rollover and make sure you did not have another rollover in the prior 12 months since taxpayers are only allowed one IRA rollover in a 12-month period.
Form W-4R is also used to advise payers of an eligible rollover distribution from an employer retirement plan of the desired withholding rate if it is other than the default rate of 20%.
Form W-4P should be completed to have payers withhold the correct amount of federal income tax from the taxable portion of a periodic pension, annuity (including commercial annuities), profit-sharing and stock bonus plan, or IRA payments. Periodic payments are made in installments at regular intervals (for example, annually, quarterly, or monthly) over a period of more than 1 year.
Calculating the Penalty – If you file your return, owe more than $1,000 and don’t meet an exception, the IRS will compute the underpayment penalty and bill you for it. However, IRS Form 2210 (2210-F for farmers and fishers) can be used to calculate the required annual payment and determine if you have underpaid in any quarter of the tax year. The form considers the amount of tax owed, estimated tax payments made, and any withholding. It then calculates the penalty based on the underpayment for each quarter until the due date of the tax return or until the underpayment is paid, whichever comes first.
If your income varies significantly throughout the year, the annualized income installment method can help reduce or eliminate underpayment penalties. This method allows you to calculate your tax liability and corresponding estimated payments based on your actual income for each quarter, rather than assuming an even income distribution throughout the year.
Farmers and Fishermen - There are special estimated tax requirements for farmers and fishermen. Farmers and fishermen, with at least two-thirds of their gross income for the prior year or the current year from farming or fishing, have two options:
They may pay all their estimated tax by January 15th (which is the 4th quarter due date for estimated taxes), or
They can file their tax return on or before March 1st and pay the total tax due at that time.
The required estimated tax payment for farmers and fishermen is the lesser of:
66 2/3% of the current year’s tax, or
100% of the prior year’s tax.
These provisions are designed to accommodate the unique income patterns of farmers and fishermen, who may not have steady income throughout the year and often realize the bulk of their income at specific times of the year.
Navigating the complexities of underpayment penalties requires a proactive approach to tax planning and payment. By understanding the rules and utilizing strategies such as adjusting withholdings, making estimated tax payments, and taking advantage of the safe harbor rule and the de minimis exception, taxpayers can avoid the financial sting of underpayment penalties. Remember, the goal is to manage your tax liability throughout the year effectively, so you're not caught off guard come tax season.
If you're unsure about your tax situation, please contact us for a tax projection and peace of mind.
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