What Is an Underpayment Penalty?

A tax penalty is imposed on an individual or corporate taxpayer 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.

Key Takeaways

  • An underpayment penalty is a fine levied by the IRS on taxpayers who don't pay enough of their estimated taxes or have enough withheld from their wages, or who pay late.
  • To avoid an underpayment penalty, individuals must pay either 100% of last year's tax or 90% of this year's tax.
  • The size of the underpayment penalty is calculated based on the outstanding amount owed and how long the amount has been overdue.
  • Generally, underpayment penalties are around .5% of the underpaid amount; they're capped at 25%.
  • Underpaid taxes also accrue interest, at a rate the IRS sets annually.

How Underpayment Penalties Work

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 they have underpaid, 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. The penalty is not a static percentage or flat dollar amount. It's based on several things, including the total underpayment amount and the period in which taxes were underpaid.

Underpayments are subject to the failure-to-pay penalty which is 0.5% of the amount owed for each month or part of a month the tax is not paid.

The underpayment's failure-to-pay penalty can't be more than 25% of the unpaid amount.

Interest Payments

Along with a penalty, tax underpayments (as well as overpayments) accrue interest. The IRS determines the interest rate every quarter, generally basing it on the federal short-term rate, plus three percentage points, for most individual taxpayers.

For Q4 2021, the rates (announced on Aug. 25, 2021) are:

  • 3% percent for individual underpayments
     
  • 5% percent for large corporate underpayments (exceeding $100,000)

Exceptions for Underpayment Penalties

Not all underpaying taxpayers face a penalty payment. It 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 exceptions mentioned above may nonetheless qualify for a reduced underpayment 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 due to the larger standard deduction. 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.