Article Highlights:
- Understanding Underpayment Penalties
- De Minimise Exception
- Safe Harbor Payments
- Payment Timing
- Withholding
- Annualized Payments
- Farmers and Fishermen
Taxpayers frequently worry about underpayment penalties, and many are unaware of how high they might be. When taxpayers underpay their taxes through withholding or anticipated tax payments throughout the course of the tax year, the Internal Revenue Service (IRS) levies these penalties. Since October 1, 2023, and at least until June 30, 2024, the interest rate for underpayments has been 8% annually, compounded daily. Just two or three years ago, that percentage was only 3%.
You may prevent undue financial hardship and fines by being aware of underpayment penalties and the techniques to avoid them. The complexities of underpayment penalties will be covered in detail in this essay, along with advice on how to successfully negotiate them.
Understanding Underpayment Penalties
In essence, underpayment penalties are the IRS's method of making sure taxpayers are paying their taxes on a quarterly basis instead of delaying until the deadline for filing taxes. According to IRS regulations, you must pay at least 90% of your taxes due in the current year or 100% of the taxes that were indicated on your previous year's return (or 100% if you are a higher-income taxpayer) throughout the course of the year. You can be charged the underpayment penalty if you don't fulfill these requirements. Consider it this way: rather of transferring your tax money to the government, the IRS is essentially charging you interest on the money you retained.
Because the penalty is computed on a quarterly basis, you may still be assessed a penalty for a quarter in which you underpaid even if you overpaid in another. The IRS sets the penalty rate, which is subject to change each quarter. Estimated tax payments are a vital tool for controlling tax liabilities and preventing underpayment penalties for self-employed people or those without adequate withholding. Although three months might seem to make up a quarter of the year, for the sake of this computation, there are really six "quarters": January through March (three months), April and May (two months), June, July, and August (three months), and lastly, the final four months of the year.
De Minimise Exception
One method to prevent underpayment fines is to utilize the de minimise exemption. You are not liable to underpayment penalties if your total tax burden is less than $1,000 after deducting your withholdings and tax credits. The benefit of this regulation is greatest for people with modest tax liabilities.
Safe Harbor Payments
Regardless of their actual tax due for the year, taxpayers who meet the IRS's safe harbor payment thresholds are shielded from underpayment penalties. Through withholding or anticipated tax payments, these benchmarks are intended to guarantee that taxpayers prepay a minimum portion of their tax liability throughout the year.
In general, taxpayers must prepay the lesser of 90% of the tax for the current year or 100% of the tax for the previous year in order to qualify for safe harbor payments. The regulations become more stringent for individuals whose adjusted gross income (AGI) exceeds $150,000 ($75,000 if married filing separately). To be eligible for this safe harbor, these people must pay the lesser of 90% of the taxes due this year or 110% of the taxes due last year. Therefore, 110% of the tax due from the prior year serves as a safe harbor that is effective in all situations. Furthermore, you are not subject to an underpayment penalty if you paid no taxes in the previous year.
The timing of these pre-payments is particularly crucial for payments to be eligible for the safe harbor penalty exemption since they include both withholding and anticipated tax payments. Estimated tax payments are due in four installments, roughly two weeks after the end of the aforementioned "quarters": April 15, June 15, September 15, and January 15 of the subsequent year. The next business day will be used as the due date if any of these days fall on a Saturday, Sunday, or official holiday. Be cautious: The dates and, occasionally, the amounts of state anticipated payments vary throughout states.
Withholding
Unlike estimated payments, withholding is considered paid evenly throughout the year, regardless of when it occurs. This can be particularly useful for taxpayers who realize they may fall short of their safe harbor requirements as the year progresses and boost their withholding by one means or another depending upon the increase required.
- An employee can increase their withholding for the balance of the year by providing their employer with a modified W-4 form that will cause the employer to increase withholding for the balance of the year.
- Where the increased withholding need is discovered closer to the end of the year, a cooperative employer might be willing to withhold a lump sum amount.
- 10% is the default withholding rate for nonperiodic withdrawals from traditional IRA accounts when you fail to provide a Form W-4R to the payer that indicates your desired withholding rate (0% - 100%). Thus by submitting a Form W-4R, or a revised one, to the payer of the IRA, requesting a higher withholding rate, additional withholding can be achieved. Where you are not employed (or even if you are), you can create more tax withholding by taking a distribution and then rolling the distribution amount back into the traditional IRA or a qualified retirement plan within the statutory 60-day time frame. To achieve this strategy you will need to make up for the withholding with other funds when making the rollover and make sure you did not have another rollover in the prior 12 months since taxpayers are only allowed one IRA rollover in a 12-month period.
- Form W-4R is also used to advise payers of an eligible rollover distribution from an employer retirement plan of the desired withholding rate if it is other than the default rate of 20%.
- Form W-4P should be completed to have payers withhold the correct amount of federal income tax from the taxable portion of a periodic pension, annuity (including commercial annuities), profit-sharing and stock bonus plan, or IRA payments. Periodic payments are made in installments at regular intervals (for example, annually, quarterly, or monthly) over a period of more than 1 year.
Calculating the Penalty
When you file your return, the IRS will calculate the underpayment penalty and bill you if you owe more than $1,000 and don't qualify for an exemption. However, you may compute the required yearly payment and find out if you have underpaid in any quarter of the tax year by using IRS Form 2210 (2210-F for farmers and fishermen). The form takes into account any withholding, projected tax payments, and the total amount of tax payable. Next, until the tax return is due date or the underpayment is paid, whichever comes first, the penalty is computed based on the underpayment for each quarter.
If your income fluctuates a lot over the year, you may be able to avoid or minimize underpayment penalties by using the annualized income installment approach. With this approach, you may determine your projected tax due and related payments according to your actual income for every quarter, instead of assuming a constant distribution of revenue throughout the course of the year.
Farmers and Fishermen
There are special estimated tax requirements for farmers and fishermen. Farmers and fishermen, with at least two-thirds of their gross income for the prior year or the current year from farming or fishing, have two options:
- They may pay all their estimated tax by January 15th (which is the 4th quarter due date for estimated taxes), or
- They can file their tax return on or before March 1st and pay the total tax due at that time.
The required estimated tax payment for farmers and fishermen is the lesser of:
- 66 2/3% of the current year's tax, or
- 100% of the prior year's tax.
These rules are intended to take into account the distinct revenue patterns of farmers and fishermen, who sometimes realize the majority of their income at particular periods of the year and may not have a consistent income throughout the year.
It takes proactive tax preparation and payment to navigate the complexity of underpayment penalties. Taxpayers can save themselves money by being aware of the regulations and employing techniques including modifying withholdings, paying estimated taxes, and invoking the de minimise exemption and safe harbor rule. Recall that the objective is to efficiently manage your tax burden throughout the year to avoid being unprepared for tax season.
For individualised guidance if you have any questions concerning your tax status, please get in touch with this office.
