An underpayment penalty may cause you a lot of headaches and inconveniences, so check out this guide to learn how you can avoid it.
In this article:
- What Is an Underpayment Penalty?
- Why Do I Have an Underpayment Penalty?
- How Much Is a Tax Underpayment Penalty?
- What Is Form 2210 Underpayment Penalty?
- How Do I Avoid Tax Underpayment Penalty?
IRS Tax Underpayment Penalty: Things To Know
1. What Is an Underpayment Penalty?
The Internal Revenue Service (IRS) requires self-employed individuals and small business owners to pay estimated taxes on income. This income may come from sources such as interest and dividends, prizes, rent, alimony, and sources other than salaries.
Taxpayers pay estimated taxes on a quarterly basis. Due dates fall on the months of April (for the first quarter), June (for the second quarter), September (for the third quarter), and January (for the fourth quarter).
Now, what is underpayment penalty? This penalty applies when a taxpayer fails to calculate and file the correct estimated taxes and resorts to paying less than the amount of tax he owes the government.
Estimated Tax Definition: taxation on sources of income outside the regular salaries and wages.
2. Why Do I Have an Underpayment Penalty?
A taxpayer will incur a penalty if the amount of his estimated tax payment fails to reach the “safe harbor payments”:
- 90% of the tax due for the current year, or
- 100% of the tax due from the previous tax year.
If the taxpayer’s adjusted gross income on his previous year’s return is over $150,000 (or over $75,000 for married taxpayers who are filing returns separately), the “safe harbor payment” is 110% of the tax due from the previous year.
Separate rules are set for farmers and fishermen. For them, the “safe harbor payment” is 66 2/3% of the tax due for the current year.
Safe Harbor Payments Definition: the amount of payment needed to avoid getting any penalty.
3. How Much Is a Tax Underpayment Penalty?
Generally, it is the IRS that will figure out the amount of penalty. For this, they determine the estimated tax underpayment penalty through the interest rate they prescribed regularly.
The IRS will send a notice and bill once they’ve calculated the amount of penalty. But if you want to determine beforehand the penalty amount, you may use Form 2210 (Underpayment of Estimated Tax by Individuals, Estates, and Trusts) as a guide.
If you committed IRS tax underpayment, and also filed it late, there is a separate penalty for that. For the first quarter of the tax year 2019, the penalty is set at 6%.
4. What Is Form 2210 Underpayment Penalty?
Form 2210 serves primarily as a personal guide on how much a taxpayer should expect to pay as a penalty for tax underpayment. Taxpayers don’t have to file Form 2210 since the IRS will determine the amount of penalty and will send a bill for it.
In this instance, the taxpayer can keep Form 2210 for his safekeeping. However, he needs to file the form and attach it to his next tax return if he encounters any of the following scenarios:
- He requested a waiver for the penalty.
- His income varied during the year, and the amount of penalty gets affected when computed using the annualized income installment method. In this case, he must figure the amount of penalty using Schedule Al.
- The amount of penalty is lower when you declare as paid the federal income tax withheld on the date it was actually withheld.
Form 2210 present three methods on how to compute tax underpayment penalty:
- short method (found on page 2 of the form). This method is applicable if the taxpayer made no estimated tax payments or if he paid the same amount of estimated tax on each of his quarterly due dates.
- regular method (found on page 3 of the form). This method is applicable if the taxpayer paid his estimated tax late and if he is filing Form 1040NR or 1040NR-EZ.
- annualized income installment method (found on page 4 of the form). This method is applicable if the taxpayer’s income varies during the year.
5. How Do I Avoid Tax Underpayment Penalty?
You will definitely avoid incurring the IRS penalty if you pay 100% of your tax due from the previous year. As for the current tax year, you have to pay at least 90% of your outstanding tax due.
Also, you will no longer have to pay any tax underpayment payment if you do the following:
- owe the IRS less than $1,000 after subtracting payments for withholding and/or estimated taxes
- managed to not incur any tax liability during the previous year
In the event that there really is underpayment, the IRS will waive penalties if you:
- cannot meet the required amount of tax payment due to unforeseen events such as casualties, disasters, or other unusual circumstances
- retired or reached the age of 62
- become disabled during the tax year or the preceding tax year
- cannot accurately compute the estimated income tax payment due to any form of tax reform
- received any excess advance premium tax credit payments
In these instances, the IRS considers that the tax underpayment happened due to a reasonable cause and not simply because of neglect or carelessness in computation.
As for farmers and fishermen, they don’t have to pay penalties for underpaying estimated taxes if:
- their gross income from either farming or fishing is at least 2/3 of their annual gross income from all income sources
- they filed Form 1040 or 1041 and paid the entire tax due on or before the first day of March
Advance Premium Tax Credit Definition: tax credit a taxpayer may take to lessen the monthly health insurance payments.
There are times when some taxpayers will get confused in computing estimated taxes and will resort to underpayment. Make sure to understand how you can avoid underpayment and avoid having to pay its penalties.
If you are having difficulties computing taxes due to changes in circumstances, it is always best to ask for a tax expert’s help on these matters to avoid such penalties.
Have you ever faced a tax underpayment penalty? Share with us your experience in the comments section below.