Tax season can be daunting for many individuals and businesses, and the last thing anyone wants to encounter is the added burden of underpayment tax penalties. In this article, we’ll explain how this penalty occurs, how to avoid it, and ways you can reduce this penalty if incurred. Understanding the ins and outs can help you plan for tax time and avoid unexpected tax bills.
What is the underpayment of tax penalty?
There are two different types of underpayment tax penalties:
- Failure to Pay Penalty: This penalty is imposed when a taxpayer does not pay the full amount of taxes owed by the tax filing deadline. It is calculated based on the outstanding tax amount and accrues daily until the tax debt is fully paid.
- Estimated Tax Penalty: For taxpayers who are not subject to withholding tax, such as self-employed individuals, freelancers, or those with significant investment income, estimated tax payments are required. If these payments fall below the required amount, or if they are not made on time, an estimated tax penalty may be imposed.
What triggers an underpayment penalty?
An underpayment tax penalty is triggered when an individual or business fails to pay enough in taxes throughout the year, resulting in an insufficient payment of their tax liability. This penalty is designed to encourage taxpayers to stay current on their tax obligations and avoid potential tax underpayments in the future.
If you owe an underpayment tax penalty, the IRS will send you a notice or letter. For more information, see Understanding Your IRS Notice or Letter.
How much is the penalty for underpaying taxes?
The amount of the underpayment of tax penalty can vary depending on several factors, including the amount of the underpayment, the period when the underpayment was due and unpaid, and the current penalty interest rate (published by the IRS quarterly).
Reasons you may have underpaid your taxes
There are several reasons why someone may find themselves facing underpayment tax penalties. One common reason is experiencing fluctuations in income or employment throughout the year, making it challenging to accurately estimate and withhold the appropriate amount of taxes.
Additionally, inconsistent tax withholding, either due to errors in W-4 forms or changes in payroll systems, can lead to unintentional underpayments. Anytime you experience a change in your financial situation you should check your W-4 to ensure you have enough withheld from your paycheck.
Unforeseen changes to tax deductions or credits, such as unexpected changes in family circumstances or eligible expenses, might also cause taxpayers to underpay their taxes.
How to avoid an underpayment penalty
The best way to avoid a penalty is to pay your correct estimated taxes on time. However, there are a few exceptions where you may have underestimated your taxes, but the IRS will not impose a penalty.
- If your filed tax return shows you owe less than $1,000 or
- If you paid at least 90% of the tax shown on the return for the taxable year or 100% of the tax shown on the return for the prior year, whichever amount is less.
The best way to avoid an underpayment penalty involves proactive tax planning throughout the year. Here are some things you can do to stay on top of your tax obligations:
- Regularly review your income and expenses: Keep track of your income sources, whether from employment, investments, or freelance work. Regularly monitor your expenses to identify any significant changes that might impact your tax liability.
- Adjust your withholding amount: If you’re an employee, review your Form W-4 and ensure that your withholding is accurate. Consider updating it whenever there are changes in your personal or financial circumstances, such as marriage, having children, or buying a home.
- Make estimated tax payments: If you’re self-employed or have other sources of income without withholding, calculate your estimated tax liability and make quarterly payments to the IRS. This will help you stay current on your tax payments and avoid penalties.
Stay updated with the latest tax updates by following the TaxSlayer Blog and be aware of any changes that may affect your tax liability.
Can I reduce my penalty?
Yes! There are circumstances in which the IRS may reduce or completely relieve you of the underpayment tax penalty.
For example, if the underpayment resulted from circumstances beyond the taxpayer’s control and they made a reasonable effort to comply with tax laws, the IRS may waive the penalty. The IRS refers to this as the Reasonable Cause exception.
Underpayment penalties may be waived or reduced if your ability to pay taxes was significantly impacted by a natural disaster, casualty, or other unforeseen events. Additionally, taxpayers who retired after reaching the age of 62 or became disabled during the tax year may also be eligible for a reduced underpayment penalty.
Circumstances like reliance on a tax professional, lack of knowledge, mistakes, oversights, or lack of funds won’t qualify as a reasonable cause that allows for an exception to the penalty.
If you believe you qualify for an exception, refer to the IRS guidelines to understand how to apply for penalty relief and dispute the penalty.
Read also: What to Do If You Can’t Pay Your Tax Bill