Understanding the IRS’s Tax Underpayment Penalty and How to Avoid It

Whether you are a freelance worker or an owner who earns money from your business, if you didn’t pay the estimated tax properly, you could end up paying an Internal Revenue Service (IRS) tax underpayment penalty. 

This article covers what can trigger a penalty and what you can do to avoid penalties in the future. 

What is a tax underpayment penalty and how does it work?

Though you only file one tax return each year, federal income tax is technically a pay-as-you-go system. You’re expected to pay tax on your income as you earn it throughout the year. Ordinarily, your employer does this for you through income tax withholding. However, if you are a freelancer, you must make your own tax payments throughout the year.

A tax underpayment penalty is a fine imposed by the IRS on individual or corporate taxpayers who don’t pay enough of their estimated taxes, don’t have enough withheld from their wages, or who pay late. The purpose of this penalty is to promote on-time and accurate estimated tax payments from taxpayers. 

The IRS may charge the tax underpayment penalty if you owe more than $1,000 in tax when you file your tax return. They may also apply this penalty if the payments you made add up to less than 90% of the tax you owe. For example, suppose that you owe $10,000 worth of tax on your 2020 tax return, but you only made $8,000 in estimated tax payments. In this case, since your tax payments only amounted to 80% of the tax due, the IRS could apply a penalty. 

The tax underpayment penalty isn’t a static percentage or flat dollar amount. Suppose the taxpayer realizes that they have underpaid taxes. In that case, they must then pay the difference plus a penalty calculated based on the remaining balance owed and how long the amount has been overdue. 

The failure-to-pay penalty that applies to tax underpayments is 0.5 percent of the amount owed for each month (or another time frame) the tax is not paid. This underpayment/failure-to-pay penalty won’t exceed 25% of the unpaid amount. 

Along with a penalty, tax underpayments (as well as overpayments) generate interest. The IRS sets the interest rate every quarter for most individual taxpayers, based on the federal short-term rate plus 3%.

The interest payment rates for Q4/2021 (announced on Aug. 25, 2021) are:

  • 3% for individual underpayments
  • 5% for large corporate underpayments (exceeding $100,000)

Exceptions for underpayment penalties

There are certain exceptions when the underpayment penalty doesn’t apply, which are: 

  • A taxpayer’s total tax liability (after withholdings and credits) is less than $1,000
  • The taxpayer paid a minimum of 90% of the total tax from the current year’s return or paid 100% of their tax liability from the previous year. (*See below for a more detailed note)
  • The taxpayer missed a required payment due to an unforeseen, uncommon, or noteworthy event (such as a casualty or disaster)
  • The taxpayer retired at age 62 or older during the prior or current tax year 
  • Estimated payments were unfulfilled because the taxpayer became disabled during the tax year or the preceding tax year
  • Any other situation in which the underpayment was due to a reasonable cause, not willful neglect. 

(*Note: In this case discussed in this second point, the rule changes a bit if your annual income increases. If your adjusted gross income for the current tax year exceeds $150,000 ($75,000 if married filing separately), you must pay 110% of your previous year’s tax liability.

However, those who don’t qualify for the above exceptions may still qualify for a reduced tax underpayment penalty in certain circumstances. For instance, individuals who change their tax filing status from “single” to “married filing jointly” may be eligible for a reduced penalty because of the higher standard deduction.

What you can do if you received a tax underpayment penalty

Generally, if you fail to pay a sufficient amount of your taxes owed throughout the year, the IRS can issue a tax underpayment penalty. However, suppose you have already paid enough and still receive a tax underpayment penalty. In that case, you may request to have it waived by showing a reasonable cause or proving that you were unable to calculate your estimated income. 

In some cases, you may successfully reduce or eliminate your tax underpayment penalty if the IRS provided you with incorrect information. For example, if you called the IRS to address a question and got the wrong advice from an IRS agent, you might succeed in avoiding a tax underpayment penalty. To be eligible for this, make sure you always note down the date and time of your call to the IRS as well as the name of the person you spoke to. If you encounter an agent who is hesitant to give you a firm answer to your question, try to be patient with them. Many agents are cautious to answer anything that could be regarded as tax advice for fear of misspeaking or giving you wrong information.

How to avoid tax underpayment penalties in the future?

No one likes ending up with a tax underpayment penalty, so here are some steps you can take to avoid this penalty in the future. 

1. Be aware of when your payments are due

For starters, adequately paying quarterly taxes by the dates shown below will help save you from incurring the underpayment penalty: 

  • Apr. 15
  • Jun. 15
  • Sept. 15
  • Jan. 15 of the following year

If a due date falls on a weekend or holiday, the payment is due the next business day.

2. Annualize your income

Generally, you don’t need to wait and pay all your tax liability at the end of the year. Especially if your income is unpredictable or seasonal, you may want to annualize your income, which basically means you will pay your tax payments based on a reasonable estimate of your income during each quarterly period. 

If you own a seasonal business and most of your annual earnings come from three consecutive months, annualizing your income can help you better estimate your tax payment. Calculating your estimated payments and making quarterly estimated payments can help you avoid the tax underpayment penalty. To use this method, you need to complete Form 2210 and attach it to your return.

For example, your business makes $30,000 per year, but all of that money comes in from June through September. When determining your estimated payments, take the $30,000 you expect to make and divide it by 12 months. This way, you can spread the amount of your estimated tax payments evenly across the year and make sure you don’t break the IRS’s pay-as-you-go rule.

3. Adjust your W-4 withholding

Generally, employers must withhold taxes from employees’ paychecks based on their earnings and employees’ information on their W-4s. If your employer isn’t withholding enough tax, you can make up the difference by revising your W-4 and requesting that they withhold more.

You can use the IRS withholding calculator to estimate how much your employer should withhold from your paychecks. Then fill out a new Form W-4, indicate how much you want to be withheld, and submit it to your employer. This can reduce or even eliminate the need for making estimated payments on your own.

The bottom line

To pay the right amount of your taxes owed throughout the years, you can ask your employer to withhold more from your paycheck. Otherwise, you can calculate and make your quarterly estimated tax payments if you’re a freelancer.

Submitting tax payments on time and filing paperwork can seem daunting, but it’s all part of developing a disciplined, well-organized documentation process. The Shoeboxed app can help your business stay efficient and organized!

Shoeboxed is a painless receipt-tracking and expense-managing app that helps get you ready for tax seasons. After scanning your receipts with the Shoeboxed app, you can create clear and comprehensive expense reports that include images of your receipts. You can then export, share or print all of the information you need for easy tax preparation or reimbursement, all within a few clicks. Shoeboxed ensures that the digital versions of your receipts are legibly scanned, clearly categorized, and accepted by both the Internal Revenue Service and the Canada Revenue Service in the event of an audit. 
The Shoeboxed app is available on iOS and Android. Try Shoeboxed for free and get yourself prepared for tax seasons!

Business Owners: Are You Forgetting This Sneaky Tax Due Date?

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Did the title freak you out a little? Sorry about that, but we thought ripping the band-aid off would be the way to go. After all, it’s the truth – if you own your own business, freelance or generally work for yourself, quarterly estimated taxes are due to the IRS and, likely, to your state’s taxing authority right around the corner.

Did you forget about them, or have never dealt with them before? Don’t worry, we’re here to help. We’ll go over what QETs are, why you have to deal with them, and some of the basics of the process to get you started.

The Basics of Quarterly Estimated Taxes

Remember back when you had a 9 to 5 or even when you worked at that fast food joint downtown while you were in high school? At the end of the pay period your boss took out a certain percentage from every paycheck to pay taxes to the government. Afterwards you got to take home what was left.

Now that you own your own business, you don’t have a boss to do this for you. This means you have to do it yourself. However, it doesn’t quite work the same as it did back then. You don’t submit your taxes every two weeks or even every month.

If you own an (for example) online coffee cup shop, every time you sell a coffee cup you might think you need to submit taxes. But that would get even more complicated than it already is, which is why the QET system was set up.

Every quarter you send in a payment to the government to take care of your tax responsibilities. January, April, June and September become your “buckle down and take care of business” months from now on.

How QETs Work

So if you don’t remit tax payments every time you make a sale, how do QETs work? If it’s your first time ever doing them it can be extremely confusing, but once you get the hang of it everything will fall into place.

The biggest thing to remember is the word “estimated.” This is precisely what these payments are – estimations, as in you’ll hardly ever run into a payment that’s 100% accurate the first time. This is because you basically take your profit from the year (that’s income minus business expenses), figure out what you would owe on taxes on those sales, and then divide by four to get your quarterly estimated tax payment.

You can probably see how this would cause unbalance. You may make most of your profits in the 4th quarter, or you may shut your business down over the summer. Therefore, this “estimate” may be a little off.

Fortunately, there’s the “Safe Harbor Rule” the IRS has put into place. As long as you submit the same amount in taxes as you owed the the year before, you won’t be charged any fees or penalties. As an example, if you accumulated a $5,000 tax bill last year, but business boomed and you owe $10,000 this year, you’ll be fine as long as you pay at least $5,000 over the year in quarterly estimated tax payments. However, you’ll have to pay up the remaining $5,000 when all is said and done and you file your annual taxes on April 15th.

The good thing about this mess, though, is that it can help you get your finances in order as well as prepare you for tax season. When the time rolls around, you’ll be so used to figuring out this kind of stuff that it’ll be a breeze.

Here’s a calendar to keep you up to date:

Q1 – April  15, 2014 (you should have already paid this one on income made from January 1 -March 31, 2014!)

Q2 – June 16, 2014 (pay on income made between April 1, 2014 and May 30, 2014; this due date falls on the 16th because the 15th is on a Sunday)

Q3 – September 15, 2014 (pay on income made between June 1 and August 31, 2014)

Q4 – January 15, 2015 (pay on income made between September 1, 2014 and December 31, 2014)

What questions do you have about QETs?

September is Tax Time: Understanding your Quarterly Estimated Taxes

If you are self-employed, a sole proprietor, a partner or an S-corporation shareholder, you may need to pay quarterly taxes. Use our helpful guide to ensure you don’t miss the deadline!

If you run your own business or are otherwise self-employed, chances are you’re required to pay quarterly estimated taxes. Instead of having a certain percentage withdrawn from each paycheck for taxes, you’re responsible for saving and paying the IRS at intervals throughout the year. This can seem like a confusing and frustrating process, but it doesn’t need to be!

If you are self-employed, a sole proprietor, a partner or an S-corporation shareholder, you may need to pay quarterly taxes. If you anticipate owing more than $1,000 in taxes at the end of the year, you definitely need to make quarterly tax payments. Form 1040-ES will help you determine and pay any taxes that may be owed.

Quarterly estimated tax payments are due on the 15th day of the months of January, April, June and September. Even if you expect to receive a refund at the end of the year, it’s still crucial to make your quarterly tax payments on time. If you don’t, you could face a hefty penalty by the IRS.

You will also face penalties if you miss any of the quarterly estimated payment due dates. It’s not okay to save up and pay your taxes as a single payment at the end of the year. If you do this, you may be subject to additional penalty fees and interest. Do your best to pay on time every quarter to avoid pointless penalty fees.

Begin by taking a look at last year’s tax return and estimating what you expect to make in the current year. Each quarterly payment should be roughly 30% of your taxable income for the previous quarter. Keep in mind that depending on your state, you may need to pay quarterly state taxes as well.

It can be difficult to save 30% of everything you make, especially if you’re a freelancer or small business owner with revenue that continually fluctuates. Even if you’re unable to pay the total amount due each quarter, it’s advisable to pay as much as you can. IRS penalties may be avoided if at least 90% of the monies owed have been paid throughout the year.

It’s better to overestimate your annual income than underestimate it. In your first few years of business, it may be difficult to see a growth pattern when it comes to your revenue, so err on the side of caution and assume you’ll make slightly more this year than you did last year. If something amazing happens and you experience exponential growth, you can make adjustments to your quarterly taxes by filling out a new 1040-ES form.

A good way to ensure you have enough saved to make quarterly estimated tax payments is to open a separate savings account specifically for tax payments. When you receive money from a customer or client, automatically transfer 30% of that payment to your tax savings account. It may not be fun, but you’ll be glad you paid on time when your refund arrives! Also, don’t forget to track receipts and expenses throughout the year so you’re always prepared come tax time.

What questions do you have about quarterly estimated taxes?