DEFINITION of 'Underpayment Penalty'

A tax penalty enacted on an individual for not paying enough of his or her total estimated tax and withholding. If an individual has an underpayment of estimated tax, they may be required to pay a penalty (on Form 2210).

BREAKING DOWN 'Underpayment Penalty'

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 occurs when a taxpayer uses IRS Form 2210 to calculate the amount of taxes he or she owes, subtracting the amount already paid in estimated taxes throughout the year. If the taxpayer realizes that he or she underpaid, he or she must pay the difference, plus a potential penalty, which is calculated based on the outstanding amount owed, and how long the amount owed 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 taxpayers 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 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.

Those who do not qualify for the aforementioned exception to the underpayment penalty may nonetheless qualify for a reduced penalty, in certain situations. For example, an individual who shifts his or her tax filing status to or from single, to married filing jointly, may be afforded a reduced penalty. A reduction may likewise be extended to taxpayers who generate significant portions of their income, later in the calendar year. On 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.

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