More and more people are getting caught by the underpayment tax penalty. Why? Particularly when you pay your taxes due by the filing deadline, generally April 15 of each year.
First, keep in mind the IRS requires you to "pay as you go." In other words, when you earn income, you should pay taxes on it, if not at each paycheck or receipt, but at least quarterly. If you are not paying as you go, you may be subject to the Underpayment Tax Penalty.
Technically called the "Underpayment of Estimated Tax by Individuals Penalty", this penalty applies to individuals, estates and trusts.
For example, you took out a large retirement distribution to buy a new car and you didn't have any tax withheld, thinking you would pay the taxes by April 15th of the next year. Your total tax is $15,000, but you only withheld $5,000 on your regular retirement and social security benefits. Will you end up getting penalized? More than likely, you will.
When the IRS assessed a penalty, you will receive a notice. If you are late paying the taxes after April 15, the IRS will also charge interest on the penalty.
Keep in mind there are 3 requirements the IRS has for paying estimated taxes to avoid any underpayments penalties. This is the smaller of:
- 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 (special rule applies to higher income taxpayers).
So, ask yourself each question:
- Will I owe less that $1,000 in tax after subtracting withholdings and credits? If so, then you don't have to pay estimated taxes.
- Did my tax payments, withholdings and refundable credits equal at least 90% of the tax shown on my return? If so, then you don't have to pay estimated taxes.
- Will my tax payments, withholdings and refundable credits be at least 100% of the tax shown on my prior year return. If so, then you don't have to pay estimated taxes.
Please note this rule for Higher Income Taxpayers who are calculating their estimated payments, "If your AGI for 2022 was more than $150,000 ($75,000 if your filing status for 2023 is married filing a separate return), substitute 110% for 100%".
If you answer, NO, to any of those question, you may need to pay estimated taxes to avoid any underpayment penalties.
For more information see IRS publication 505. See the chart on Chapter 2. Estimated Tax.
Also see this IRS FAQ on Estimated Taxes. Also, see this IRS FAQ about Pay As You Go.