Underpayment Penalty Definition

Underpayment Penalty

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An underpayment penalty is a fine levied by the IRS on taxpayers who don't pay enough of their estimated taxes, don't have enough withheld from their wages, or pay late. To avoid an underpayment penalty, individuals generally must pay at minimum either 100% of last year's tax or 90% of this year's tax.

Learn how underpayment penalties work and more about how you can avoid them.

What Is an Underpayment Penalty?

A tax penalty is imposed on individual or corporate taxpayers for not paying enough of their total estimated tax and withholding due. Taxpayers should consult Form 2210 to determine if they are required to report an underpayment and pay a penalty.

Key Takeaways

  • An underpayment penalty is a fine levied by the IRS on taxpayers who don't pay enough tax during the year through withholding and/or their estimated taxes, or who pay late.
  • To avoid an underpayment penalty, individuals generally must pay the lesser of 100% of last year's tax or 90% of this year's tax.
  • If your AGI for last year exceeded $150,000, you must pay the lesser of 110% of last year’s tax or 90% of this year’s tax.
  • Typically, underpayment penalties are 5% of the underpaid amount, and they're capped at 25%.
  • Underpaid taxes also accrue interest at a rate the IRS sets annually.

How Underpayment Penalties Work

The tax law requires that taxpayers make payments as they realize income throughout the year through withholding, estimated taxes, or both. To avoid an underpayment penalty, individuals whose adjusted gross income (AGI) is $150,000 or less must pay the lesser of 90% of the current year's tax or 100% of last-year’s tax, by combining estimated and withholding taxes. Individuals whose AGI for the preceding taxable year exceeds $150,000 must pay the lesser of 90% of the tax due for the current year tax or 110% of the tax on the individual’s return for the prior taxable year.

The underpayment penalty is owed when a taxpayer underpays the estimated taxes or makes uneven payments during the tax year that do not correspond adequately to the taxpayer’s current income for a period. Taxpayers with self-employment income should take their liability for Social Security and Medicare taxes into account when calculating the amounts due.

Some taxpayers, such as sole proprietors, partners, and S Corporation shareholders, must pay taxes in four equal payments during the year. In some cases, taxpayers who receive their income unevenly may be able to pay different amounts quarterly. Taxpayers should use IRS Form 2210 to determine if their payments of withholding and estimated taxes during the year are sufficient to avoid a penalty.

If taxpayers realize that they have underpaid, they must pay the difference—plus a penalty that 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 and the part of a month for which the tax is not paid.

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

Interest Payments

Along with a penalty, tax underpayments (or overpayments) accrue interest. The IRS determines the interest rate every quarter, generally basing it on the federal short-term rate, plus 3 percentage points, for most individual taxpayers.

For Q3 2022, the rates (announced on May 30, 2022) are:

  • 5% percent for individual underpayments
  • 7% percent for large corporate underpayments (exceeding $100,000)

Example of Underpayment Penalty

For example, if you owed $5,000 in taxes for the year, but only paid $2,000, you would have underpaid your taxes by $3,000.

Because the amount is over $1,000 and you did not pay at least 90% of what you owed, you would be subject to an underpayment penalty (unless you met other criteria for avoiding it). The penalty would be the federal short-term rate plus 3 percentage points. For Q3 2022, that rate would be 5%, or $150.

How to Avoid Underpayment Penalty

The best way to avoid an underpayment penalty is to take steps to ensure your tax obligations are fully paid on time.

You can also avoid the underpayment penalty if your tax return shows you owe less than $1,000. You can also avoid this fee if you paid 90% or more of the tax that you owed for the taxable year or 100% of the tax you owed for the year prior, whichever amount is less.

The under payment penalty may also be waived by the IRS under several other scenarios, including:

  • The taxpayer was a U.S. citizen or resident for the preceding tax year and did not owe any taxes for that year
  • The taxpayer missed a required payment because of a casualty event, disaster, or other unusual circumstance
  • The underpayment was the result of reasonable cause and not willful neglect
  • The taxpayer retired after reaching age 62 during the current or preceding tax year
  • The taxpayer became disabled during the tax year for which estimated payments were owed or during the preceding tax year

Special Considerations

If you do not qualify for the exceptions to the underpayment penalty, you may qualify for a reduced underpayment penalty in some situations. For example, an individual who changes their tax filing status from single to married filing jointly may get 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 in December, triggering a substantial capital gains tax.

What are Underpayment Penalties for 2022?

For the third quarter 2022, IRS underpayment penalties for individuals are 5% for individual underpayments and 7% for large corporate underpayment over $100,000. Underpayment penalties is the federal short-term rate plus 3 percentage points.

What are IRS “Safe Harbor” Rules?

"Safe harbor" rules are rules that allow you to not pay a penalty or pay a reduced penalty if you meet certain conditions. An underpayment penalty with the IRS can be avoided if you meet conditions like owing less than $1,000 or paying more than 90% of your tax obligation for the year.

Can you Make Estimated Tax Payments All at Once?

Some taxpayers, such as sole proprietors, partners, and S Corporation shareholders, must pay taxes quarterly if they will owe more than $1,000. Their payments are called estimated tax payments. You cannot pay estimated tax payments all at once. You must pay them each quarter.

Article Sources
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