How Is Tax Underpayment Penalty Calculated?

Estimated Tax Payments

The United States operates a pay-as-you-go tax system. According to this system, you are expected to retain or pay estimated taxes as you earn or collect salary. However, if you are self-employed and you fail to pay adequate quarterly estimated taxes, the IRS can impose a penalty on you.

The underpayment penalty is calculated according to the amount you owe, including the duration it was owed. The normal penalty is 0.5% of the overall amount you owe calculated for each month you haven’t paid it.

When it comes to underpayment penalties, there exit several grey areas taxpayers wish they understood. One of them is how the penalty is calculated, how it can be prevented, and why it is being imposed.

How Is Tax Underpayment Penalty Calculated?

The U.S. adopts a pay-as-you-go tax scheme that requires taxpayers to pay their taxes as they earn. If you decide to play smart and pay too little, you could find yourself staring at a massive tax bill, including an underpayment penalty. An underpayment penalty is a penalty imposed on taxpayers who fail to pay enough towards his or her tax obligation in a year. Taxpayers who find themselves in this situation can calculate the resulting penalty by themselves (with the aid of the 1040 or 1040A forms), or have the IRS calculate it for them.

When your annual tax return is filed, the IRS will carry out these calculations:

  • First off, they will evaluate the estimated tax you ought to have paid each quarter.
  • Afterwards, the agency will deduct the amount previously paid in withholding and estimated taxes to determine the underpayment.
  • Next, the IRS will evaluate the penalty by including the interest rate to the overdue amount owed per quarter.
  • Finally, they’ll sum up the penalty amount for all four quarters to arrive at the overall underpayment penalty that is due.

After the calculations, the IRS will send you a bill stating the penalty sum that is owed. You will also have to pay the difference between the tax you’ve paid and the amount owed, including the underpayment penalty.

In some cases, taxpayers are not subject to this penalty. The IRS will disregard an underpayment penalty in the light of some occurrences. We’ll be looking at that later on in this article. The penalty charged for tax underpayment isn’t the same every year; it varies. You should also note that the amount of your penalty hinges on your specific situation. If you decide to calculate it yourself, you will have to request for a 2210 form. The 2210 form, which can be obtained from the IRS, comes with a short and regular method for calculating your penalty.

What Does Underpayment Mean?

So far, we have mentioned the word “underpayment” 12 times in this article. Even at that, not everyone can confidently define what the word underpayment means. I bet most of us can! Anyways, to those who can’t, I’ll be providing you with a brief definition of what the term underpayment means.

Underpayment is simply when someone pays less than required or less than the value of a thing. If you are supposed to pay someone $45 for a rendered service, and you end up paying $15, it is safe to say that you have underpaid.

Having been clarified on what it means, you should have less problem grasping what an underpayment penalty is.

common penalties for individuals

What Is the IRS Penalty for Underpayment of Taxes?

Tax offences are committed by taxpayers daily. These range from, late filing, late payment, failure to state taxable income or transactions, negligence, and tax underpayment. As a cautionary measure, the IRS usually dish out punishment to individuals who are found guilty of these offences.

For tax underpayment, the penalty is usually 0.5% of the amount owed for each month of the nonpayment. However, the good news is that not everyone found guilty of this act will face the penalty. The IRS will disregard the penalty under some circumstance.

The IRS, as we know, is sometimes strict with their penalties. If found guilty, there is no escaping them. To ensure that you don’t become a victim of this, make it a habit to do the needful. Don’t play silly games with the IRS because you will be shooting yourself in the foot if you decide to. Make your estimated tax payments on time and steer clear from underpayment at all cost. To be on the safer side whenever you tender your tax return, always check to know if the IRS received it. You could also contact a tax expert for advice and clarification if needed.

Should I Let the IRS Calculate Underpayment Penalty?

The IRS often mete out various punishments to taxpayers who fail to adhere to their rules. One of the various punishments in their Arsenal is the underpayment penalty. It is a fine imposed on taxpayers who fail to pay adequate tax via withholdings or estimated payments. It can be calculated by two entities: you, or the IRS.

You can decide to calculate the underpayment penalty with the aid of a form 2210 or leave the job to the IRS.

However, you must make use of the form 2210 if:

  • You requested a waiver of the penalty.
  • You decide to make use of the annualized income method in schedule AI or form 2210
  • You decide to assign withholdings to the period they were held instead of having the overall withheld amount assigned evenly over the payment duration.

If the above mentioned doesn’t apply to you, you can leave the calculation to the IRS. It saves you the stress of doing the calculation yourself. As soon as the IRS is done with the calculation, they will send you a bill for the penalty amount.

Are you aware that you can file back taxes without records? Yes, it is possible and the process is quite easy!

Why Do I Have a Penalty for Underpayment of Estimate Tax?

No one likes to be punished, even for crimes we commit. The IRS doesn’t share such thoughts. This agency, which is a household name in the US, will ensure that you get the punishment you deserve when you fail to abide by their rules. Mind you, they have plenty of these rules, and this makes not falling into their bad books much harder. It has come to our notice that there are some taxpayers out there who don’t know why they are penalized for underpaying estimate tax.

You were penalized for underpaying estimate tax because you failed to pay enough of your overall estimated tax with withholding. It is that simple! To prevent this penalty, you must pay either 100% of the previous year’s tax or 90% of this year’s tax, by merging approximated and withholding taxes.

In some cases, taxpayers who underpay their estimate tax are pardoned by the IRS. Don’t rejoice yet because you will only be pardoned under certain circumstances. It would help if you took note of these circumstances before you start rejoicing. Finally, you must note that punished taxpayers may be forced to pay interest rates on the penalty.

civil penalties assessed, by type of tax, fiscal year 2019

How Do I Calculate IRS Penalties and Interest?

As a taxpayer, you must note that failure to abide by IRS rules will likely lead to punishment. These punishments vary for each offence. However, one of the most common punishments adopted by the IRS is penalties and interest. The penalties and interests are most times calculated by the IRS. But come to think of it, wouldn’t it be nice if you knew how the penalties and interest are calculated?

Among the two punishments the IRS can throw at you, the interest is quite easy to calculate. To calculate the IRS interest, you have to determine the federal short-term interest rate. The short-term interest rate plus three equals the IRS interest rate. The IRS penalties, on the other hand, is calculated based on the type. A late payment penalty is calculated as 0.5% of what you owe for each month (or part of the month) you are late, reaching a max of 25% (if you owe the IRS a balance).

Also, if you fail to file your tax return early, the IRS will impose more severe punishment on you. The sanction for failing to file is usually 5% of the owed amount for each month (or part), which totals a 4.5% late filing fee including the 0.5% late payment fee. To know more about the IRS interest and penalty, obtain the IRS interest and penalty information.

How Can I Avoid IRS Penalty for Underpayment of Taxes?

If you have had a glimpse of the IRS penalty for underpayment of taxes, you wouldn’t want to do anything that would make them impose such penalty on you. The penalty may not be too severe, but on the long-run, you may find yourself staring at a huge tax bill. Just like every other IRS penalties, the underpayment penalty can be avoided. It all boils down to doing the right thing.

To avoid the IRS penalty for underpayment of taxes, adopt these three tips:

  • Pay Your Estimated Taxes According to What You Owe the Previous Year.
  • Ensure You Make Annualized Estimated Tax Payments
  • Raise Workplace Withholding

Let’s take a closer look at the tips mentioned above.

Pay Your Estimated Taxes According to What You Owe the Previous Year:

One of the best ways to avoid the IRS penalty for underpayment of taxes is by doing the needful. Ensure that the overall amount of approximated taxes you pay throughout the year is equal to not less than 90% of the taxes you owe for the current year or 100% of the taxes you owe the previous year.

No one likes paying more than they supposed to, be it for a commodity, a service or even taxes. Several people attempt to estimate payments to hit the 90% mark accurately. But, this can be a challenge for the self-employed folks whose revenues rise and fall year in year out. It is also a huge challenge for individuals who earn from investments such as stocks whose profits are unpredictable.

One of the best ways to handle this troubling issue is to adopt the previous year’s tax liability and consider paying 100% of the amount in approximated payments in the current year. But how do you get your four quarterly payments for the present year? Quite simple. Take the amounted owed in taxes for the previous year, and voila, you have your four quarterly estimated tax payments for the current year. If these payments are made early, you won’t be penalized for tax underpayment. But, there exist two crucial details you need to remember if you consider using this tactic to estimate your taxes for the year.

  • Ensure that you go by taxes owed and not taxes paid
  • The rules are not the same for higher incomes.

Ensure You Make Annualized Estimated Tax Payments:

For individuals whose income ebb and flow year in year out, making estimated tax payments can be quiet difficult, especially during trying times. However, thanks to the IRS, there is a solution to this issue. The solution is annualized payments.

Rather than paying your estimated tax liability for the year in four same-sized quarterly payments, this method allows you to make estimated payments that show the flow of the business in the course of the year.

However, you must note that making annualized payments isn’t a simple task. You will have to work more and do extra record keeping rather than making four same-sized payments. You will need to keep close tabs on your earnings and expenses as the year goes by and calculate your estimated tax payments on these figures every quarter. In addition, irrespective of the method you adopt to arrive at your estimated tax payments, you will still be required to pay estimated taxes on a minimum of 90% of your earning for the year to keep the penalties at bay.

Raise Workplace Withholding:

If you have income that isn’t subject to withholding, you will have to pay estimated tax. Examples of income that isn’t subject to withholding are earnings from freelance work and self-employment, including pension income.

If peradventure, you have an income that is subject to withholding, you can go ahead and modify the withholding to cover the income from other sources. For instance, if you are a freelancer and you also do a 7-7 job at a mall, you can raise the withholding amount at your 7-7 job to cover for the income of your freelance job. With this method, you won’t have to pay estimated tax or the resulting penalties.

Married couples can also adopt this tactic in situations where one spouse has an income that is subject to withholding, and the other doesn’t.

Does the IRS Waive Underpayment Penalty?

The IRS is not as cruel as some taxpayer imagine them to be. Of course, sometimes their penalties may be severe, but also remember that you wouldn’t have been in that position if you had abided by their rules. The underpayment penalty can bite you hard, especially if your case is a severe one. However, there is good news!

The IRS can waive an underpayment penalty, but it doesn’t work like magic. This agency won’t waive the penalty just like that. No, it doesn’t work that way. In fact, such a gesture of goodwill only happens in certain situations. So don’t rejoice yet.

If you didn’t make estimated tax payment because of a casualty, disaster or any severe situations, the IRS might decide to pardon you. The IRS may also pardon you if your decision to ignore the payment wasn’t intentional or if one of their agents gave you the wrong advice. There are also other circumstances. So you see, the IRS isn’t cruel after all.

How Can I Get an Underpayment Penalty Waived?

The underpayment penalty is imposed on taxpayers who pay less than what they are supposed to. This penalty is quite common among the self-employed, individuals with investments, the retired, etc. Having known that the underpayment penalty is pardonable, the next question on your mind should be the “how?”

The IRS won’t waive your underpayment penalty if you aren’t eligible for this kind gesture. Your underpayment penalty will be waived if:

  • There is a reasonable cause behind the act.
  • You retired or got disabled.

There is a reasonable cause behind the act:

If you can prove that you tried your best to meet the deadline, but certain situations behind your control stopped you from doing so, the IRS may pardon you. These situations could range from a natural disaster, a casualty, a death in your immediate family, etc.

You retired or got disabled:

The IRS can also waive your underpayment penalty if you retired after clocking 62 or you got disabled on the tax year or in the previous tax year, and there is a good reason behind the underpayment.

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