What Is An Underpayment Penalty & Do You Have To Pay It?
No one likes paying taxes, but avoiding them adds to your tax liability and penalties. We break down what an underpayment penalty is, when it applies, and how to avoid it.
Let’s face it: No one likes paying taxes. But dragging your feet when it comes to paying your taxes can cause you to owe the Internal Revenue Service even more money through interest and fees. One of those fees is an underpayment penalty.
Whether you’ve received an underpayment notice from the IRS or you’re just looking to avoid underpaying on your taxes, this post is for you. We’re going to break down what an underpayment penalty is, when it applies, how to avoid getting hit with this penalty, and more. Keep reading to learn more about underpayment penalties.
Table of Contents
What Is An Underpayment Penalty?
An underpayment penalty is a monetary fine imposed by the Internal Revenue Service on a taxpayer that fails to pay enough of their tax liability throughout the year or pays late. It is the taxpayer’s responsibility to ensure they pay enough taxes through the year, either through estimated quarterly payments or payroll tax withholdings, and to pay on time.
If the amount paid isn’t enough to cover their tax liability, they will not only be required to pay the remainder of their tax liability but may also be required to pay an underpayment penalty. There are a few exceptions to these rules, which we’ll discuss in later sections.
How Do Underpayment Penalties For Payroll Taxes Work?
In the United States, taxes are paid under a pay-as-you-go system. For self-employed taxpayers and owners of pass-through businesses, this is done by paying quarterly estimated taxes. For employees, taxes are withheld from your paycheck based on the number of deductions calculated on IRS Form w-4, Employee’s Withholding Certificate.
Missing the deadline for paying quarterly estimated taxes or failure to pay the taxes at all will often result in an underpayment penalty. In other words, you will end up paying more (and in some cases, a significant amount more) to the IRS on top of your tax liability.
Underpayment Penalty Exemptions
There are a few scenarios in which a taxpayer would be exempt from paying an underpayment penalty. These situations include:
- Your total tax liability is less than $1,000
- You paid at least 90% of taxes owed
- You did not owe taxes in the previous year
- You reached age 62 and retired during the year the underpayment was made
- You were unable to make payments as a result of an emergency, natural disaster, or casualty; this includes those impacted by the COVID-19 pandemic
- You became disabled during the tax year the underpayment was made
- Most of your income tax was withheld early in the year
Even if you do not qualify to have your penalty waived, you may still qualify for a reduced penalty based on y0ur specific situation (e.g., your income varies throughout the year). If you’re unsure if you qualify for a waived or reduced penalty, talk to a CPA or tax professional to learn more.
Another thing to note is that the rules differ for farmers and fishermen. If you’re in these professions, contact a CPA or tax professional for advice about your situation.
How To Calculate An Underpayment Penalty
A number of factors are used to calculate the amount of your underpayment penalty. The following factors contribute to how much you will end up paying as a penalty to the IRS:
- The amount of the underpayment
- The date the underpayment was due
- The current quarterly interest rate
Let’s break down the process to show how underpayment penalties are calculated.
Step 1: Calculate The Amount Of The Underpayment
First, determine the underpayment amount. You can either review your financial records yourself or hire an accountant or tax professional to help you throughout the process.
The underpayment is the amount due to the IRS that was not paid on time or at all. Let’s look at a quick example:
- You paid $2,500 for the first quarter
- You paid $2,500 for the second quarter
- You paid $2,500 for the third quarter
- You paid $1,000 for the fourth quarter
- This adds up to a total of $8,500 for the year
In this example, let’s say that your total tax liability was $10,000. You were actually supposed to pay $2,500 for the fourth quarter. Because you only paid $1,000, there is a deficit of $1,500. This is the amount of underpayment.
Step 2: Determine If You Qualify For An Exemption
If you determine that you did not pay enough taxes during the year, there’s a good chance you will have to pay an underpayment penalty. However, there is a chance that you may qualify for an exemption. As a reminder, you can receive an exemption only under very specific circumstances, e.g., if you were the victim of a disaster, became disabled, or owed less than $1,000. If you are unsure if your situation qualifies you for a waived or reduced penalty, reach out to a tax professional or accountant.
Step 3: Check Current Interest Rates
Interest accrues on your IRS underpayment penalty, so it’s important to pay the amount due as quickly as you can. When calculating interest, there are two rates you need to know:
- The federal short-term interest rate
- The IRS’ quarterly rate
For the quarter beginning January 1, 2022, the quarterly rate is 3%. Beginning on April 1, 2022, this rate will increase to 4%.
The IRS short-term interest rate is 0.22% (as of March 2022). Remember, these numbers can fluctuate, so please make sure to confirm the current rates before calculating your penalty.
Add the federal short-term interest rate and the quarterly rate together to get the underpayment penalty interest rate. For the current rates quoted above, this would equal 3.22%.
Continuing with our example, let’s say that you didn’t pay enough in estimated taxes following the due date of January 15, and you owe $1,500. You are paying on January 30. The interest owed is $48.30 based on the rate of 3.22%. Add this to your tax obligation of $1,500, and you will have to pay the IRS $1,548.30.
The interest for underpayment compounds daily, meaning that your amount owed will continue to increase the longer you wait to pay. This is why it is imperative to determine if you owe the IRS and pay your tax obligation as soon as possible.
One last thing to note is that rates for corporations are different than rates for individuals and pass-through businesses.
Step 4: Use Form 2210 To Calculate Your Underpayment Penalty
If you don’t qualify for an exemption and you didn’t pay your full tax liability throughout the year, you will owe an underpayment penalty in addition to the remaining tax amount due. To calculate the underpayment penalty, you will use IRS Form 2210, Underpayment of Estimated Tax by Individuals, Estates and Trusts.
Even if you’re unsure whether or not you will be required to pay a penalty, it’s a good idea to check out Form 2210 anyway. That’s because it offers a flow chart and guidance to help you determine whether a penalty applies.
Additionally, you will also use Form 2210 to apply for a waiver if you qualify.
Step 5: Submit Payment To The IRS
After you have calculated your penalty and have filled out Form 2210, you will need to submit a payment to the IRS. There are several ways to do this, including:
- Online via credit card, debit card, or digital wallet
- Money order
- Same-day wire
- Electronic funds withdrawal while e-Filing
- Cash through an IRS retail partner
How To Avoid Underpayment Penalties
Underpayment penalties can get quite complicated (and expensive!) It’s just best to avoid the hassle of getting hit with an underpayment penalty by following these tips:
Know Your Due Dates
Not paying your estimated quarterly taxes on time can result in penalties, so take note of the following dates:
- April 15
- June 15
- September 15
- January 15 (of the following year)
Note that these days may vary slightly if they fall on a weekend or holiday. If this occurs, the due date will be the next business day.
Accurately Estimate Your Tax Liability
Accurately gauging your estimated quarterly taxes is key to avoiding an underpayment penalty. It may be tempting to skip steps or lowball your estimate, but this will catch up to you and will cost you more money in the long run. For an accurate estimate, you will need:
- Expected adjusted gross income
- Taxable income
- Credits for the year
You can use Form 1040-ES to calculate your estimated taxes. Once you have your calculations, don’t forget to submit your payment by the due dates discussed earlier.
Apply For A Payment Plan
If you don’t have the funds to pay your tax liability, you can apply for a payment plan through the IRS. Though this doesn’t protect you from all fees, it can significantly lower the amount of interest and fees you have to pay, all while allowing you to pay your tax debt off over time. The IRS has made this option easier than ever by allowing taxpayers to apply for a payment plan directly from the IRS website.
Other Payroll Tax Penalties
If you are a small business owner, there are other penalties to be aware of if you fail to pay taxes on time or at all. These include:
- Penalties on unpaid withholding taxes (payroll taxes)
- Penalties for information returns
- Penalties for failure to timely file a return
- Penalties for failure to timely pay taxes due
- Penalties for inaccurate returns resulting in additional tax owed
Penalties may include monetary fines, liens, interest on back taxes, and even criminal and civil sanctions.
The Bottom Line On Underpayment Penalties
Paying taxes is unavoidable. Failing to pay the correct amount of taxes or submitting a payment past the due date will only cause your tax obligation to grow. Make sure that you’re accurately calculating your estimated taxes and paying by each due date.
If you happen to get hit with an underpayment penalty, don’t avoid it. Pay as quickly as you can, and if you can’t afford to pay, reach out to the IRS to set up a payment plan. It’s a common misconception that the IRS is a nightmare to work with, and you’ll find that working with them will make the whole process go much smoother.
Make sure you’re ready this tax season by checking out our other small business tax posts. Learn more about payroll taxes with The Ultimate Payroll Tax Guide For Small Businesses. Then, make sure you check off every box of The Ultimate Small Business Tax Checklist to be fully prepared for filing and paying your taxes. Good luck and happy filing!