How is Tax underpayment penalty calculated?

The tax system in the United States of America functions on the pay-as-you-go mechanism. Most employees are known to pay taxes through the process of paycheck withholding. However, if you are not qualified for withholding or it is not capable of covering all the tax obligations, then you are expected to pay the estimated taxes quarterly. However, what happens when you are not able to pay the respective estimated taxes? Unfortunately, you might end up with underpayment of estimated tax penalty. This is wherein you can think of using the IRS penalty and interest calculator.

To understand what could lead to a penalty, it is important to know about estimated taxes and other crucial concepts. For beginners, the adequate payment of quarterly taxes by the stipulated dates should prevent you from incurring the overall penalty for underpayment of estimated taxes. For taxpayers following the calendar year, some important dates to keep a note of are:

• 15^th April
• 15^th June
• 15^th September
• 15^th January of the following year

Wish to know more about how to avoid the penalty for underpayment of taxes? Let us help you understand in-depth.

What is Underpayment Penalty?

The term ‘underpayment penalty’ can be defined as the tax that is imposed by the IRS on subsequent taxpayers who are not capable of paying enough of the estimated taxes, end up paying late, or do not have ample withheld from the respective wages. If you wish to avoid the underpayment penalty for your taxes, you are expected to ensure the payment of either 100 percent of the tax amount of the previous year or 90 percent of the tax of the ongoing year. 

A tax penalty is generally applied on individuals for not paying enough for the total estimated tax as well as withholding due. Taxpayers are expected to go through the Form 2210 towards determining whether or not they are required to report the cause of underpayment or pay the desired amount of penalty.

Understanding the Working of Underpayment Penalties

The tax law in the United States of America requires that the respective taxpayers should ensure payments upon realizing their income across the span of the entire year through estimated taxes, withholdings, or even both. To avoid the underpayment of tax penalty, individuals who have the AGI or Adjusted Gross Income of less than $150,000 are expected to pay less than 90 percent of the tax of the ongoing year or 100 percent of the previous year’s tax. It is achieved by combining withholding and estimated taxes. 

Individuals having the AGI more than $150,000 are expected to pay lesser amount of the 90 percent of the current year’s tax due or 110 percent of the tax on the overall returns of the individual for previous year’s taxes.

The underpayment penalty of taxes is applicable when the taxpayer goes ahead with underpaying the estimated taxes or making uneven payments throughout the tax year -not corresponding to the current income of the taxpayer for the given period. Taxpayers featuring income out of self-employment are expected to take the liability for Medicare and Social Security taxes into consideration while calculating the due amount.

Some taxpayers -including partners, proprietors, and S Corporation holders, are expected to pay taxes in the form of 4 equal tax payments during the given year. Under some conditions, taxpayers receiving the income unevenly are able to pay taxes at different periods or different amounts quarterly. 

When taxpayers realize that they have underpaid the tax amount, they are expected to pay the difference amount. Additionally, there is also the involvement of a penalty that gets calculated on the basis of the outstanding amount that is due and the period for which the amount was due. The penalty should not be regarded as a flat dollar amount or some static percentage. It can include several factors -including the period during which taxes were underpaid and the total amount of underpayment. 

Calculating the IRS Underpayment Penalty for Taxpayers

The calculation of underpayment penalty can be slightly complicated. It is because -unlike most other penalties imposed by the IRS, the underpayment penalty is not a flat dollar amount or a static percentage. You can make use of a reliable IRS penalty and interest calculator by FlyFinn to calculate the same.

You can also use the Form 2210 along with a proper worksheet from the instructions of Form 2210 to calculate the penalty. However, if you insist on calculating the penalty manually instead of using a software solution, it is recommended to go through some complicated instructions. Keep a calculator handy. You can also ask the IRS to calculate the penalty amount for you and send over the same through a proper bill.

There are specific taxpayers who might be exempted from paying the underpayment penalty. The IRS can go ahead with waiving the underpayment penalty in case of the following conditions -until you are able to prove some reasonable cause and not any willful neglect from your end:

• You got disabled during the specific tax year. Due to this, you were not able to meet the respective tax obligations.
• You were not able to make enough payments. It might be due to some unforeseen circumstances, a natural disaster, emergency, or casualty. 
• You retired (aged 62 years) during the particular tax year in which underpayment of taxes took place. 
• Most of the income tax paid by you was withheld earlier during the taxation year. 

Ways to Avoid Underpayment Penalty

One of the easiest ways to avoid the underpayment penalty for taxes is by paying 100 percent (or even 100 percent if you are a high-income taxpayer) of the previous year’s tax amount. If you have some penalty with the previous year’s returns and wish to avoid getting a penalty in the upcoming filing session, here are some ways to try out:

#Adjusting the Withholding

When you receive a paycheck from the employer, file out the all-new Form W-4 or the Employee’s Withholding Certificate. The form is helpful in telling the respective employer how much tax should be withheld from the paycheck for every payment period.

You can make use of the Tax Withholding Estimator or IRS penalty and interest calculator to analyze the total amount of federal income tax to be withheld from the paycheck. You can submit the all-new W-4 form to the concerned payroll department. Avoid mailing it to the IRS.

#Ensuring Quarterly Estimated Tax Payments

If you follow the trend of self-employment or possess income that is not eligible for withholding (like capital gains, interests, or dividends), then you are expected to ensure estimated payment of taxes throughout the tax year.

In most cases, the payments for estimated taxes are due on dates -including 15^th April, 15^th June, 15^th September, and 15^th January of the upcoming year. If the given dates will fall on some holiday or weekend, the deadline will eventually shift to the next business day. It is important to be cautious about these deadlines. It is because if you end up making the tax payments later than the deadline, it could result into underpayment penalty -even when you do not owe any additional tax while filing the returns.

Analyze the total amount of tax on the returns of the previous year. Divide the value by 4. Pay at least the given amount on every due date of estimated tax payments to avoid the underpayment penalty.

#Using the Annualized Instalment Practice

If you have a seasonal business or are self-employed, it can be a difficult process to ensure four equal estimated tax payments. For instance, if you have a boating company, you will end up earning a majority of your income during the summer months or late spring while closing up your business during the winter season.

If this is the case, you can make use of the annualized instalment process to avoid the penalty for underpayment of taxes. To make use of the given method, you can go ahead with filling out the Annualized Estimated Tax Worksheet. It is available within IRS Publication 505. You can fill out the worksheet towards the end of the period for the payment of estimated tax. It will help in calculating the required payment amount. 

Underpayment Penalties for 2022

For the 3^rd quarter of 2022, the underpayment penalties by the IRS for individuals are 5 percent for individual underpayments. At the same time, it is 7 percent for large-scale corporate or organizational underpayment over the amount of $100,000. Underpayment penalties can be regarded as the federal short-term rate along with three percentage points.