Understanding The US Tax Underpayment Penalty And How To Avoid It

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While filling out your tax return this year, maybe you discovered a nasty little surprise: you’re being hit with an Underpayment Penalty, an extra little whack on the nose that means the IRS would like to hear from you more often throughout the year. Why?

Understanding the Underpayment Penalty

When you calculate the amount of tax that you owe, along with however much you’ve had withheld or paid in estimated tax throughout the year, if you haven’t had enough withheld, the IRS will assess a penalty for underpayment. How much is enough? The penalty is based upon the lesser of two amounts:

  • 90% of the amount of tax you will pay in total for the current year; or
  • 100% of the amount of tax you paid for the previous year.

Note: These amounts are different if you are a farmer or fisherman by trade – in that case, you use 66 2/3% of the tax you’ll pay instead of 90%. In addition, if you are not a farmer or fisherman by trade, and your income is greater than $150,000  or $75,000 for Married Filing Separately, the factor you use is 110% of the amount of tax you paid the previous year, rather than 100%. For the purpose of this article, we’ll just use the “regular” figures.

If the amount of withholding and estimated payments that you’ve made throughout the year is at least $1,000 less than the smaller of those two factors, you’re in a position to receive an underpayment penalty.

Calculating Your Estimated Tax

The IRS has Form 1040ES to help you determine the amount of tax that you should be withholding or making in estimated payments. It’s a little complicated and daunting, but if you bear with it you can come up with the proper numbers to make sure you’re covering the tax throughout the year.

With the information that you get from Form 1040ES, you will have calculated the amount of under-withholding – if it turns out that you’re over-withholding, you might make adjustments to your W4’s or estimated payments as well, but that’s another topic altogether. No action is necessary if the calculated under-withholding is less than $1,000.

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