An underpayment penalty is a fine levied by the Internal Revenue Service (IRS) on taxpayers who don’t pay enough of their estimated taxes, don’t have enough withheld from their wages, or pay late. Individuals must generally pay at least 100% of last year’s tax or 90% of this year’s tax to avoid an underpayment penalty.
Key Takeaways
- An underpayment penalty is a fine levied by the Internal Revenue Service (IRS) on taxpayers who don’t pay enough tax during the year through withholding and/or their estimated tax payments, or who pay late.
- Individuals generally must pay the lesser of 100% of last year’s tax or 90% of this year’s tax to avoid an underpayment penalty.
- You must pay the lesser of 110% of last year’s tax or 90% of this year’s tax if your adjusted gross income (AGI) for last year exceeded $150,000.
- Underpayment penalties are typically 5% of the underpaid amount and they’re capped at 25%.
- Underpaid taxes also accrue interest at a rate that the IRS sets quarterly.
What Is an Underpayment Penalty?
A tax penalty is imposed on individuals or corporate taxpayers who haven't paid enough of their total estimated tax and withholding that's due. Taxpayers can consult IRS instructions for Form 2210 to determine whether they're required to report an underpayment and pay a penalty.
How Underpayment Penalties Work
The tax law requires that taxpayers make payments as they receive income throughout the year through withholding, paying estimated taxes, or both.
To avoid an underpayment penalty, individuals whose adjusted gross income (AGI) is $150,000 or less must pay the lesser of 90% of the current year’s tax or 100% of last year’s tax by combining estimated and withholding taxes. Individuals whose AGI for the preceding taxable year exceeds $150,000 must pay the lesser of 90% of the tax due for the current year or 110% of the tax on the individual’s return for the prior taxable year.
The underpayment penalty is owed when a taxpayer underpays their estimated taxes or makes uneven payments during the tax year that do not correspond adequately to the taxpayer’s current income for a period.
Taxpayers with self-employment income should take their liability for Social Security and Medicare taxes into account when calculating the amounts due.
Some taxpayers, such as sole proprietors, partners, and S corporation shareholders, must pay taxes in four equal payments during the year, although they can do so more frequently than that. Taxpayers who receive their income unevenly may be able to pay different amounts quarterly in some cases. Taxpayers can use IRS Form 2210 to determine if their payments of withholding and estimated taxes during the year are sufficient to avoid a penalty.
Taxpayers must pay the difference plus a penalty that is calculated based on the outstanding amount owed and how long the amount has been overdue if they realize that they've underpaid.
The penalty isn't a static percentage or a flat dollar amount. It’s based on several things, including the total underpayment amountand the period during which taxes were underpaid. Underpayments are subject to the failure-to-pay penalty, which is 0.5% of the amount owed for each month and the part of a month for which the tax is not paid.
The underpayment failure-to-pay penalty can’t be more than 25% of the unpaid amount.
Interest Payments
Tax underpayments and overpayments accrue interest as well. The IRS determines the interest rate every quarter, generally basing it on the federal short-term rate plus three percentage points for most individual taxpayers.
The rates were 8% for individual underpayments and 7% for large corporate underpayments for the fourth quarter (Q4) of 2023 and the first quarter (Q1) of 2024.
Example of an Underpayment Penalty
You would have underpaid your taxes by $3,000 if you owed $5,000 in taxes for the year but only paid $2,000. The amount is more than $1,000 and you didn't pay at least 90% of what you owed so you would be subject to an underpayment penalty unless you meet other criteria for avoiding it. The penalty would be the federal short-term rate at the time plus three percentage points. That rate is 8% heading into 2024, or $240.
How to Avoid an Underpayment Penalty
The best way to avoid an underpayment penalty is to take steps to ensure that your tax obligations are fully paid on time. You can also avoid the underpayment penalty if:
- Your tax return shows you owe less than $1,000.
- You paid 90% or more of the tax that you owed for the taxable year or 100% of the tax that you owed for the year prior, whichever amount is less.
The underpayment penalty may also be waived by the IRS under several other scenarios, including:
- The taxpayer was a U.S. citizen or resident for the preceding tax year and did not owe any taxes for that year.
- The taxpayer missed a required payment because of a casualty event, disaster, or other unusual circ*mstance.
- The underpayment was a result of reasonable cause and not willful neglect.
- The taxpayer retired after reaching age 62 during the current or preceding tax year.
- The taxpayer became disabled during the tax year for which estimated payments were owed or during the preceding tax year.
Special Considerations
You may qualify for a reduced underpayment penalty in some situations if you don't qualify for the exceptions to the underpayment penalty. For example, an individual who changes their tax filing status from single to married filing jointly may get a reduced penalty due to the larger standard deduction.
A reduction might also be extended to taxpayers who generatesignificant portions of their income late in the calendar year. One such example is an investment holding that was sold in December, triggering a substantial capital gains tax.
What Were the Underpayment Penalties for 2023?
The IRS underpayment penalty was 7% for most underpayments and 9% for large corporate underpayments through the first three quarters of 2023. It increased to 8% in Q4.
What Are IRS "Safe Harbor" Rules?
“Safe harbor” rules allow you to not pay a penalty or to pay a reduced penalty if you meet certain conditions. An underpayment penalty with the IRS can be avoided if you owe less than $1,000 or pay more than 90% of your tax obligation for the year.
Can You Make Estimated Tax Payments All at Once?
Some taxpayers, such as sole proprietors, partners, and S corporation shareholders, must pay taxes at least quarterly if they will owe more than $1,000. These payments are referred to as estimated tax payments. You cannot pay estimated tax payments all at once, although you can do so in advance and you can pay monthly in advance if that suits your budget better.
The Bottom Line
You could end up paying an underpayment penalty if you don't pay enough in estimated taxes, tax withholding, or taxes due. Check to see if you qualify for an exemption or reduced penalty if you're charged a penalty. The best way to avoid underpayment penalties is to be sure that you figure estimated taxes correctly and pay your taxes on time. You might also want to adjust your tax withholding with your employer if you're not self-employed.
