Tax Series, Part Two: How to Calculate and Avoid Underpayment Penalties
The IRS operates on a “pay-as-you-go” system, not just an April deadline. They expect taxes to be paid throughout the year as income is earned, not in one lump sum at tax time. If you underpay in certain quarters, underpayment penalties can kick in, even if your total tax bill is eventually paid in full. In this post, we will walk through how the penalty works and how to stay ahead of it.
What Is an Underpayment Penalty?
This penalty is based on how much you underpaid and when the underpayment occurred during the year. To avoid it, you generally need to meet one of the IRS’s safe harbor rules:
- Pay at least 90% of your total current-year tax liability, or
- Pay 100% of last year’s tax liability (110% if your adjusted gross income was over $150,000 for married filing jointly taxpayers)
Let’s say a taxpayer expects to owe around $20,000 in total for the tax year. Using the IRS’s safe harbor rules, let’s assume $18,000 (90%) is the target. The taxpayer makes the following estimated payments:
- Q1 (April 15th): $1,000
- Q2 (June 15th): $1,000
- Q3 (September 15th): $1,000
- Q4 (January 15th): $15,000
Since the IRS expects estimated payments to be spread out evenly throughout the year, the taxpayer should have paid $4,500 per quarter. For Q1, Q2, and Q3, they underpaid by $3,500 each. If we assume an average underpayment interest rate of 8% annually or 2% per quarter, the total penalty would be $210. We take $3,500 multiplied by 2% applied to three quarters to come to this conclusion.
Who’s Most at Risk?
Underpayment penalties are more common for taxpayers whose income is inconsistent throughout the year. Self-employed individuals often face this issue because their income can fluctuate from month to month. Retirees taking variable income from sources like pensions or retirement accounts may also be at risk. Those with irregular income from bonuses, restricted stock units (RSUs), capital gains, or other non-wage sources may find themselves in a similar circumstance.
Strategies to Avoid the Underpayment Penalty
In my last blog post, I focused primarily on how to avoid the penalty utilizing Form 2210 with Schedule AI for taxpayers with irregular income. As a reminder, using this form with assistance from a CPA lets you report the income earned in the quarter and subsequently reduces or avoids penalties altogether.
If you receive a salary but have other income sources, adjusting your W4 midyear can be helpful. Increasing your withholdings on W2 income can serve as a catch-up mechanism because withholdings are treated as even payments, unlike quarterly estimated tax payments. This also applies to withholdings on retirement income from IRAs or pensions. This is also an excellent strategy for retirees doing Roth conversions later in the year.
If you are proactive with your tax planning, underpayment penalties can be easily avoidable. Whether you have irregular income and utilize Form 2210 or receive a salary and adjust your withholdings later in the year, these strategies can help you stay on track. It’s important to understand how these penalties are calculated so you can estimate what you may need to withhold or submit in estimated tax payments. The best way to navigate these strategies is to work with a CPA who can offer valuable advice and planning for your financial circumstances.