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.
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