What Is an Underpayment Penalty?
An underpayment penalty is a fine charged by the Internal Revenue Service (IRS) when taxpayers don’t pay enough of their estimated taxes due during the year, don’t have enough withheld from their wages during the year, or pay late.
The underpayment is reported and the fine is applied when the taxpayer completes the annual tax return. Taxpayers must generally pay at least 90% of their taxes due during the previous year to avoid an underpayment penalty. The fine can grow with the size of the shortfall.
Taxpayers can consult IRS instructions for Form 2210 to determine whether they're required to report an underpayment and pay a penalty.
Key Takeaways
- The penalty is charged when taxpayers don't pay enough through payroll withholding or fail to pay enough when filing quarterly.
- Taxpayers who pay late also are fined.
- The usual penalty is the amount owed plus 5% of the underpayment amount. It's capped at 25%.
- Underpaid taxes accrue interest at a rate that the IRS sets quarterly.
How Underpayment Penalties Work
The tax law requires that taxpayers make payments as they receive income throughout the year.
For employees, estimated taxes are withheld from paychecks based on information the employee provides in a W-4 form.
Self-employed people and business owners are required to file quarterly tax returns and pay estimated taxes due for the period. Others who must file quarterly include people with investment income and landlords.
How to Avoid an Underpayment Fine
The best way to avoid an underpayment penalty is to ensure that your taxes are fully paid on time.
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 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 to the taxpayer’s current income for a period.
When the Penalty Is Waived
A penalty will not be imposed if:
- Your tax return shows you owe less than $1,000.
- You paid 90% or more of the tax that you owed for the taxable year or 100% of the tax that you owed for the year prior, whichever amount is less.
The underpayment penalty may also be waived for several other reasons, 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 circ*mstance.
- The underpayment was a result of a 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.
Taxpayers with self-employment income need to take into account their liability for Social Security and Medicare taxes 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, although they can do so more frequently. Taxpayers who receive their income unevenly may be able to pay different amounts quarterly in some cases.
Taxpayers can use IRS Form 2210 to determine if their payments of withholding and estimated taxes during the year are sufficient to avoid a penalty.
How the Fine Works
Taxpayers 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 isn't a static percentage or a flat dollar amount. It’s based on several factors, including the total underpayment amountand the period during 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 is capped at 25% of the unpaid amount.
Interest Payments
Tax underpayments and overpayments accrue interest as well. The IRS determines the interest rate every quarter, generally basing it on the federal short-term rate plus three percentage points for most taxpayers.
The rates were 8% for individual underpayments and 7% for large corporate underpayments for the fourth quarter (Q4) of 2023 and the first quarter (Q1) of 2024.
Example of an Underpayment Penalty
If you owed $5,000 in taxes for the year but only paid $2,000, you would have underpaid your taxes by $3,000.
You paid less than 90% of what you owed so you would be subject to an underpayment penalty. The penalty would be the federal short-term rate at the time plus three percentage points. That would add up to about 8%, or $240, as of mid-2024.
Special Considerations
You may qualify for a reduced underpayment penalty even if you don't qualify for the exceptions to the underpayment penalty. 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 generatesignificant portions of their income late in the calendar year. For example, if a taxpayer sold an investment in December, triggering a substantial capital gains tax, the penalty might not be applied.
Sometimes, the IRS might make an error in assessing interest or a penalty against a taxpayer. Taxpayers can file Form 843 to request the correction of the error.
What Were the Underpayment Penalties for the 2023 Tax Year?
The IRS underpayment penalty was 7% for most underpayments and 9% for large corporate underpayments through the first three quarters of 2023. It increased to 8% in the fourth quarter.
What Are IRS "Safe Harbor" Rules?
IRS safe harbor rules allow you to avoid a penalty or pay a reduced penalty if you meet certain conditions. An underpayment penalty with the IRS can be avoided if you owe less than $1,000 or pay 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 at least quarterly if they will owe more than $1,000. These payments are referred to as estimated tax payments.
You cannot pay estimated tax payments all at once unless you do so at the beginning of the year. You can pay monthly in advance if that suits your budget better.
The Bottom Line
You could end up paying an underpayment penalty if you don't pay enough in estimated taxes, tax withholding, or taxes due. Check to see if you qualify for an exemption or reduced penalty if you're charged a penalty.
The best way to avoid underpayment penalties is to be sure that you pay your taxes on time, meaning around the time you earn it, not the following April.
If all or nearly all of your income is from an employer, you shouldn't have an underpayment problem. If you do, check the details on your W-4 form for errors that caused your employer to withhold less than necessary from your paycheck.
