Contributed by: JoshuaC, FreeTaxUSA Agent, Tax Pro
An underpayment penalty is a charge the IRS may add when you don’t pay enough tax during the year. In some cases it can apply even if you pay the full amount by the tax filing deadline.
As you prepare your tax return in FreeTaxUSA, you may see a prompt to enter information about a possible underpayment penalty. If you've already filed your tax return, you may receive a letter from the IRS, such as a CP30 Notice, saying you've been charged a penalty for not paying enough tax during the year. This article reviews how this penalty works, why you might unexpectedly find it added to your tax owed, and how you can avoid it in the future.
Pay tax as you earn
The U.S. tax system operates on a "pay-as-you-go" basis. The IRS expects you to pay taxes on income throughout the year as it is earned, rather than simply paying everything owed at once when you file your tax return. This means, even if you pay your total tax bill by the filing deadline, the IRS may still assess this penalty if your payments weren't made throughout the year.
If you're employed, your employer usually withholds taxes from each paycheck for you. The amount withheld is based on the information you provide on Form W-4 when you’re hired. Your employer may have you fill out the form directly or use an interview-style tool to gather the information needed to fill out the form on your behalf.
Your withholding amount is also affected by factors like the number of dependents you claim and any other income you report. You'll want to fill out a new W-4 to update your withholdings when there are significant changes to your dependents or other income, to make sure your withholding stays accurate.
💡 Note: If your state has an income tax as well, it may use the federal W-4 or have a separate state-specific version designed to account for differences in the state's tax structure.
If you have income that doesn’t have automatic withholdings, such as self-employment income, you’ll usually need to make those tax payments yourself. Payments of estimated tax are typically expected quarterly.
Common reasons for a penalty
Income tax withholding from your wages is usually enough to cover the tax owed on your tax return. But it’s more likely to fall short if you have a second job, are married and both spouses work, or have other income sources (rental properties, investment sales, etc.) which aren’t factored into your withholding. A significant raise or bonus may also increase your income above what your base withholding covers.
Another factor that can impact your tax bill is a change in the number of dependents on your tax return. If you have fewer dependents than in previous years, or a dependent reaches age 17, you may lose access to tax credits you were counting on. This could mean you end the year owing more than expected, which could trigger an underpayment penalty.
How to avoid a penalty
The short answer to avoiding the underpayment penalty is to ensure you’re paying enough tax throughout the year to cover what you expect to owe. If you have an employer, this means making sure your withholding accurately reflects your income and dependent situation. Update your withholding when you have a life change, such as a raise, marriage, or new dependents.
You can also make estimated tax payments directly to the IRS for each quarter of the year. Anyone can do this, but it’s especially important for individuals who don’t have income tax regularly withheld from their income.
You don't need to estimate the exact amount of tax due for the year, but to safely avoid an underpayment penalty, you’ll need to satisfy at least one of three "safe harbors":
- Your remaining tax bill, after withholdings and credits, is less than $1,000.
- You pay at least 90% of your tax liability for the current year.
- You pay at least 100% of your tax liability from the previous year (special rules apply for higher income taxpayers, or taxpayers with farming or fishing income).
In conclusion, it can be frustrating to pay your taxes only to find an additional penalty for not paying enough on time. By being proactive in managing your tax payments throughout the year, you can avoid this kind of surprise.
Additional Resources:
https://www.irs.gov/payments/underpayment-of-estimated-tax-by-individuals-penalty
https://www.irs.gov/payments/pay-as-you-go-so-you-wont-owe-a-guide-to-withholding-estimated-taxes-and-ways-to-avoid-the-estimated-tax-penalty
https://www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes