What Is an Underpayment Penalty?

A tax penalty is imposed on an individual for not paying enough of their total estimated tax and withholding due. If an individual has an underpayment of estimated tax, they may be required to pay a penalty. Form 2210 is used to report the payment.

Breaking Down Underpayment Penalties

To avoid an underpayment penalty, individuals must pay either 100% of last year's tax or 90% of this year's tax, by combining estimated and withholding taxes.

The underpayment penalty is owed when a taxpayer underpays the estimated taxes or makes uneven payments during the tax year that result in a net underpayment. IRS Form 2210 is used to calculate the amount of taxes owed, subtracting the amount already paid in estimated taxes throughout the year.

If the taxpayer realizes that there is an underpayment, they must pay the difference plus a penalty which is calculated based on the outstanding amount owed and how long the amount has been overdue. Typically, the penalty is 0.5 percent of the amount owed, for each month of nonpayment.

Not all underpaying taxpayers face a penalty payment, which may be waived under several scenarios, including:

  • A taxpayer's total tax liability is less than $1,000.
  • The taxpayer did not owe any taxes for the previous year.
  • The taxpayer paid at least 90% of the taxes owed.
  • The taxpayer missed a required payment because of a casualty event, disaster, or other unusual circumstance.
  • The taxpayer retired after reaching age 62.
  • The taxpayer became disabled during the tax year or during the preceding tax year for which estimated payments were unfulfilled.
  • Any other situation where the underpayment was the result of a reasonable cause and not willful neglect.

Special Considerations

Those who do not qualify for the exception mentioned above to the underpayment penalty may nonetheless qualify for a reduced penalty in some situations. For example, an individual who changes their tax filing status to or from single to married filing jointly may be afforded a reduced penalty. A reduction might also be extended to taxpayers who generate significant portions of their income late in the calendar year. One such example is an investment holding that’s sold off in December, thereby triggering a substantial capital gains tax.

It should be noted that penalized taxpayers may be subjected to interest rates on the penalty. For taxpayers other than corporations, the overpayment and underpayment rate is the federal short-term rate plus three percentage points.