IRS Underpayment Penalties and How to Avoid Them

Did you know that if you owe the IRS money and you don’t pay them by the deadline, they will charge you a penalty? In this blog post, we’ll explain the possible penalties you may be charged for underpaying your taxes, and we’ll also give you some tips on how to avoid them.

What is an IRS Underpayment Penalty?

You are required to pay a certain amount of your taxes in advance throughout the year, or you risk being charged underpayment penalties.

Typical W2 employees pay taxes via paycheck withholdings, which is pretty painless. However, 1099 independent contractors must calculate and submit tax payments independently.

Regardless of your filing status, it’s ultimately up to you to ensure you pay sufficient taxes on your income.  You tell your employer how much to take out of your check via tax form W4, so it’s not their fault if you underpay.

The IRS can impose an underpayment penalty on taxpayers who don’t pay enough tax. This can include not paying enough estimates early in the year or under-withholding on paychecks.

When calculating required estimated tax payments, self-employed individuals should also account for Social Security and Medicare (self-employment) taxes.

How to Avoid Underpayment Penalties

Your required tax payments throughout the year must be the least of:

  • 100% of your prior year’s taxes or
  • 90% of the current year’s taxes

If your Adjusted Gross Income (AGI) for the prior year is $150,000 or more, you must pay the less of:

  • 110% of your prior year’s taxes or
  • 90% of the current year’s taxes

Withholdings from your paycheck are assumed to be spread evenly throughout the year, while estimated taxes are considered to be paid as of the date you make the payment.

You can make uneven estimates during the year if your income varies throughout the year. To avoid underpayment penalties on varying income, you’ll need to file Form 2210 to report your income every quarter.

What are the Penalties for Underpayment?

Underpayment penalties incur at a rate of 0.5% of the unpaid tax for each month or partial month that the tax remains unpaid.

Underpaid taxes and penalties currently accrue interest of 5% for individuals and 7% for corporations.

The interest rate for underpayment penalties changes yearly based on current interest rates. The IRS will likely raise interest rates based on the Fed’s recent interest rate changes.

Underpayment penalties are capped at 25% of the tax due.

If a taxpayer earns wages of $100,000 and has a tax due of $18,200. The taxpayer only withheld $10,000 of federal taxes from their paychecks. The taxpayer had similar earnings, taxes, and withholding for the prior tax year. In this case, the taxpayer’s required withholdings for the year are 90% of the current year’s tax ($18,200 * .9 = $16,380). The under-withholding in this scenario is $16,380 – $10,000 or $6,380. This amount would be subject to penalties and interest.

What if I Can’t Afford to Pay IRS Underpayment Penalties?

If you have under-withheld your taxes for the year, you will have a balance due on tax day, along with interest and penalties.

You should still file your tax return if you do not have the funds available to pay your balance due. You should also pay as much of the balance due as possible. The IRS will send you a bill for the unpaid taxes, penalties, and interest once they have processed the return.

Once the IRS has processed your return, you can apply for a payment plan. A payment plan can reduce future penalties for non-payment of taxes. You will still be charged interest on the balance.

Will the IRS Ever Reduce or Remove a Penalty?

It is possible to get out of some IRS penalties. There are several possible scenarios where you can waive or reduce the penalties.

If you or your spouse (if you file a joint return) retired in the past two years after reaching age 62 or became disabled, you had reasonable cause to underpay or pay your estimated tax late; you may be eligible. You can complete a Waiver of Penalty on Form 2210 and include an explanation of the reasonable cause for underpayment.

If you had most of your income tax withheld late in the year instead of spreading it equally throughout the year, you might be able to reduce or remove the penalty.  You should Complete Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts PDF.

If your income varies during the year, you must show the IRS how your payments match your income. You’ll need to complete Form 2210, Schedule AI, and Annualized Income Installment Method (found within the form).

If none of the above apply to you, but you’ve always paid your taxes on time and have filed all your prior year’s tax returns, you may be eligible for a first-time penalty abatement. You will need to contact the IRS via phone and ask for the waiver to be applied.

How to Dispute an Underpayment Penalty

In some scenarios, an underpayment penalty may be reduced or removed.

The IRS might make an adjustment to a penalty if you relied on incorrect written advice from the IRS gave. Note that the advice must be written and not verbal.  If this is the case, follow the steps below to dispute the penalty:

  • Mail a statement signed under penalty of perjury that describes how the IRS’s erroneous written advice resulted in the penalty.
  • Include a copy of both the written request for advice you sent to the IRS and the IRS’s written response.
  • Mail the original statement and copies of the supporting documents to the address on your penalty notice.
  • Make sure to keep a copy of the documents you send to the IRS.

You can learn more about disputing an IRS penalty on the IRS website

Final Thoughts

A penalty notice from the IRS is no reason to panic. Depending on your specific circumstances, there are several possible ways to get the penalties reduced or waived.

To avoid underpayment penalties, you need to make sure to pay the required taxes throughout the year and be ready to pay any outstanding balance on tax day.

If you have more questions about your business’s tax outlook, let’s talk! The experts at Shared Economy Tax specialize in taxes for independent contractors and small businesses. Set up a one-on-one strategy session with one of our tax pros today to see how much you can save!