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Underpayment penalties are a common concern for taxpayers, and many are unaware of how substantial they can be. The Internal Revenue Service (IRS) assesses these penalties when taxpayers fail to pay enough 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 1st, 2023, and at least through June 30th, 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 navigating these waters effectively.
Underpayment Penalties - Underpayment penalties are essentially the IRS's way of ensuring taxpayers pay their taxes quarterly rather than waiting until the tax filing deadline. The IRS requires that you spend 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. The IRS effectively charges you interest on the tax money you keep instead of sending it to the government.
The penalty is calculated every quarter, meaning that if you underpaid in any given quarter, you might be penalized for that quarter even if you overpaid in another. The IRS determines the penalty rate, which can vary from quarter to quarter. For self-employed individuals or those without sufficient withholding, estimated tax payments are critical in managing tax liability and avoiding underpayment penalties. You would think that a quarter of the year would be three months, but for 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 four months of the year.
De Minimis Exception - The de minimis exception is one way to avoid underpayment penalties. You won't be subject to underpayment penalties if your total tax liability minus your withholdings and tax credits is less than $1,000. This rule is particularly beneficial for taxpayers with a relatively small tax liability.
Safe Harbor Payments - Safe harbor payments are benchmarks set by the IRS that, if met, protect taxpayers from underpayment penalties, regardless of their actual tax liability for the year. These benchmarks ensure taxpayers prepay 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, 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 15th, June 15th, September 15th, and January 15th of the following year, approximately two 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 payment 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 need to catch up to their safe harbor requirements as the year progresses and boost their withholding by one means or another, depending upon the increase required.
Employees can increase their withholding for the year's balance by providing their employer with a modified W-4 form that will cause the employer to increase withholding for the year's balance.
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. To achieve this strategy, you must make up for the withholding with other funds when making the rollover and ensure you did not have another rollover in the prior 12 months since taxpayers are only allowed one IRA rollover in 12 months.
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 more than one 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. However, IRS Form 2210 (2210-F for farmers and fishers) can 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 tax return's due date or until the underpayment is paid, whichever comes first.
The annualized income installment method can help reduce or eliminate underpayment penalties if your income varies significantly throughout the year. This method allows you to calculate your tax liability and corresponding estimated payments based on your quarterly income 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 then.
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 have little 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 effectively manage your tax liability throughout the year so you're aware of tax season.
Please get in touch with this office for personalized advice and peace of mind if you need clarification on your tax situation.
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