Updated: March 1, 2020
Skipped some tax payments last year? You may be on the hook for a fine from Uncle Sam known as the penalty for underpayment of estimated tax.
Read on to get the lowdown on the penalty and how to determine whether you owe it and how to calculate it.
What is the penalty for underpayment of estimated tax?
America operates on a pay-as-you-go tax system. This means taxpayers have to pay taxes as they make money, not in a lump sum. They can pay taxes through withholding or by making estimated tax payments.
But you may owe a penalty if you do not pay enough in withholding or estimated tax payments during the year. The IRS calls this the penalty for underpayment of estimated tax.
When is the penalty waived?
Typically, a penalty applies if too little is paid during the year. In some cases, the penalty is waived if tax payments during the year met one of the following tests:
- The person’s tax payments were at least 90 percent of the tax liability
- The person’s tax payments were at least 100 percent of the prior year’s tax liability
The IRS may also choose to waive the penalty if:
- You didn’t make a payment because of a casualty, disaster or some other out-of-the-blue event
- You retired (after 62) or became disabled during this or the prior tax year
In these cases, tax non-payment missed due to a reasonable cause and not knowing neglect may prove acceptable by the IRS.
There are some more exceptions for farmers and fishers and some household employers. You can find these in IRS Publication 505.
How do you know if you owe the penalty?
Plan to prepare and file your tax return using tax software? The software will assess the penalty and alert you to the amount you owe based on your income and the amount of tax you paid during the year.
Calculating your taxes by hand? Use Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts to determine whether you owe the penalty. Or, use Form 2220, Underpayment of Estimated Tax by Corporations. The form contains a flowchart that will help you find out whether you owe a penalty.
How do you figure the penalty for underpayment of estimated taxes?
Learned from Form 2210/2220 that you do owe the penalty for underpayment of estimated tax? The chart will also tell you whether you need to file Form 2210 (and which pages to file). The rest of the questions in the form will instruct you how to figure your penalty.
You will first figure what you paid versus owed in taxes each quarter. This information is used to calculate your per-quarter penalty amount. Then you will then total your quarterly penalties to get your total penalty amount.
According to the IRS, interest rates on underpayments will remain the same at 5% for the calendar quarter beginning January 1, 2020. The rates will be:
- 5% for overpayments (4% in the case of a corporation)
- 2.5% for the portion of a corporate overpayment exceeding $10,000
- 5% for underpayments
- 7% for large corporate underpayments
For taxpayers other than corporations, the underpayment rate is the federal short-term rate plus 3 percentage points, whereas the overpayment rate is the federal short-term rate plus 2 percentage points. These rates are determined by the IRS on a quarterly basis.
How do you avoid the penalty for underpayment of estimated taxes?
The best way to avoid the penalty for underpayment of estimated taxes? Make sure you pay enough in taxes year-round.
Employees who get their taxes withheld can file a new Form W-4 to change their withholding. The best time to review your W-4 for needed changes is early in the year. But you can file a new W-4 anytime before the end of the year.
The self-employed do not have taxes withheld from their self-employment income. Most, but not all, of these taxpayers must make estimated tax payments four times a year every quarter. Use Form 1040-ES to ensure you calculate your estimated tax payments right.
When you make your estimated tax payments also factors into the penalty amount. So be sure to meet the four estimated tax deadlines each year. The dates for 2020 are as follows:
- April 15, 2020
- June 17, 2020
- September 16, 2020
- January 15, 2020