The Internal Revenue Service (IRS) underpayment penalty can cause some people to unexpectedly owe more than they think on their taxes. Ideally, you pay your taxes throughout the year as you have income through your job. Most employers automatically take out taxes and make sure they get paid, but freelancers and others who draw income through nontraditional means may need to keep up with those payment needs on their own.
Failing to pay your taxes throughout the year could result in an IRS underpayment penalty. Not only that, it could leave you unaware of how much you actually owe — which could mean you are scrambling to pay your taxes at the end of the year.
What is the Underpayment Penalty?
The IRS underpayment penalty is a fee imposed for people who do not pay their taxes throughout the year or do not have enough withheld from their paychecks. You may owe an underpayment penalty if you failed to pay at least 80% of the taxes you owed throughout the year. If your income increased substantially in the current calendar year and you did pay 100% of the amount you owed last year, you may be able to avoid the underpayment penalty.
How to Estimate the Taxes You Owe
If you are employed in a traditional employment arrangement, your employer can guide you through appropriately withholding taxes. You may have a lower tax burden based on your number of dependents, for example. Make sure you keep your information updated with your employer any time your status changes.
If you work as a freelancer, on the other hand, you should expect to pay an average 25% to 30% of your taxable income in taxes since you will also need to self-pay Social Security and Medicare taxes. Calculate your estimated taxes carefully to make sure you do not underpay.
Which Underpayments Result in Penalties?
Sometimes, underpayments will not necessarily result in penalties. You should expect to pay a penalty if:
- You paid less than 80% of the taxes owed
- You owe more than $1,000 in taxes
- You willfully chose not to pay your taxes for the year
Individuals who receive their paychecks through a company should set up their withholding properly through their employers to reduce the odds that they will face unnecessary fees and underpayment penalties. Individuals who freelance or own their own small business should plan to make quarterly payments to the IRS to keep up with their tax payments and avoid underpayment. These quarterly payments may reflect actual taxable income or be set up to equal annual taxable income over the course of the year.
For example, if you know that you will experience higher levels of income during the holidays, you might choose to pay a higher tax payment during the earlier quarters of the year to avoid unexpectedly higher payments during the fourth quarter.
How Much is the IRS Underpayment Penalty?
Failure to pay your taxes on time can result in a penalty of approximately 2% of your estimated debt. If you owe less than $1,250, the penalty will be the lesser of $25 or 2% of the owed payment.
Who Qualifies for an Underpayment Exception?
While many people face the IRS underpayment penalty each year, you can apply for an exception to that penalty that will allow you to pay your tax debt without the penalty. Here’s what you need to know:
- Most of the time, you will need to show that your underpayment occurred due to lack of knowledge or inability to pay if you want to qualify for an underpayment exception.
- Your failure to pay can not be due to malice or deliberate omission on your part.
For example, you will not face an underpayment penalty if your income in the previous calendar year was much lower, and you made estimated tax payments in the amount of last year’s owed taxes. Likewise, you may receive exceptions for several important events. Here are some of the ways you can qualify for an exemption.
You faced a financial disaster or emergency that made it impossible to pay.
A medical emergency used all of your funds. You lost your job and needed to use funds set aside to pay your taxes to handle other important bills. You suffered a financial catastrophe that, for whatever reason, required you to use your available funds to make those payments. If you can show undue financial hardship or disaster that led to your inability to pay, the IRS may waive your underpayment fee.
You retired or became disabled during that calendar year.
Retiring or facing disability can create significant changes in your income status and tax burden, which can make it difficult for you to keep up with needed payments. The IRS may waive your fees due to disability or retirement.
You did not owe taxes for the previous year.
Suddenly passing a threshold during which you owe taxes can be a surprise. The IRS will often waive the fees if you did not owe taxes the previous year, which led to you not realizing that you would owe more taxes this year.
Your total tax liability is less than $1,000.
If you owe less than $1,000 in taxes, the IRS will waive the fee. This may include your total tax liability — not just the amount you owe due to underpayment — so it’s critical to ensure that you keep up with it throughout the year.
To apply for a fee exemption, make sure you consult an experienced tax attorney to make sure that you fill out the forms properly and submit appropriate evidence. Freelancers and small business owners must exercise care each year to ensure that they take care of their taxes on time. Quarterly tax payments will help keep you up-to-date and ensure that you do not face costly underpayment penalties.
Never Miss a Tax Payment Again
Have you been properly calculating your taxes and making your payments on time? Are you curious about how much you will actually owe this year or how to ensure that you haven’t missed any payments? Contact Silver Tax Group today to speak with an expert about any IRS underpayment penalty questions you might have.