Contributed by: ChristopherT, FreeTaxUSA Agent, Tax Pro
One of the worst feelings when tax day arrives, is discovering you not only owe tax but also a penalty for underpayment of taxes. When you’re charged an underpayment penalty, you’ll owe additional money on top of the tax you already need to pay. Below we’ll cover the underpayment penalty, estimated taxes, and what steps you can take to potentially help you avoid paying this penalty.
The system
The IRS works on a “pay as you go” system. This means the IRS expects you to pay a certain amount of tax as you go throughout the year. For most taxpayers, this is typically covered by income taxes being withheld from their wages.
However, if you reach a higher income level or your income comes from a source that doesn't inherently withhold tax – such as self-employment income - you may find yourself with an underpayment penalty. In this case, the IRS expects you to make quarterly estimated tax payments.
Underpayment penalty
The underpayment penalty applies to individuals who haven’t paid enough tax in the “pay as you go” system. When this happens, the IRS calculates a penalty based on the amount of underpaid tax, the period when it was due and the interest rate for the period, published quarterly.
There are three conditions the IRS uses when determining whether you may end up paying an underpayment penalty.
- You owe less than $1,000 in tax after subtracting withholdings and credits, or
- You paid at least 90% of the tax for the current year, or
- You paid 100% of the tax shown on the return for the prior year (there's a special rule for higher income taxpayers).
Taxpayers can monitor tax being withheld in the current year and compare this to the amount of tax owed in the prior year. If you don't meet one of the above conditions, you may be required to make estimated tax payments to supplement the tax withheld from your other sources of income or, you may include Form 2210 on your tax return to figure the penalty and make changes to Estimated Tax Payments in the current year.
Estimated tax payments
You can make payments to the IRS for estimated tax payments at any time. The IRS breaks the year into four quarters for reporting purposes:
- January 1st – March 31st
- April 1st – May 31st
- June 1st – August 31st and
- September 1st – December 31st.
When preparing your return, payments are reported on Form 1040 as an estimated tax payment by following this menu path: Misc > 2024 Estimated Tax Payments.
There are a variety of ways to make estimated tax payments to the IRS. The easiest and most common method is using the IRS’ website and paying online. That process typically starts from the IRS’ Make a Payment page.
The wrap up
The underpayment penalty can be a surprise to many taxpayers. However, with some record keeping and tracking of earnings and withholdings, the penalty can be avoided completely.
If you’re still not sure whether you need to make estimated tax payments, the Estimated Payments instructions provide worksheets that can help you determine how much you’ll need to pay in advance. You can access those at this link: About Form 1040-ES
