In the US, federal income taxes are a pay-as-you-go system. This means the IRS requires you to pay estimated taxes throughout the year—either via withholding from paychecks or by making quarterly estimated payments—as you earn income.
Doing so helps you avoid an IRS underpayment penalty.
What Is the IRS Underpayment of Estimated Tax Penalty?
The IRS Underpayment of Estimated Tax penalty applies if you didn’t withhold enough taxes or didn’t pay enough estimated federal income taxes.
Of course, knowing exactly how much tax you’ll owe each year can be challenging, especially if your income, deductions, and available tax credits change from year to year. For that reason, the IRS offers a “safe harbor” method for calculating your estimated payments.
The safe harbor method allows you to avoid an underpayment penalty if:
- You owe less than $1,000 in tax after subtracting your withholding and refundable credits, or
- You paid at least 90% of the tax you owe via withholding or estimated payments or 100% of the tax shown on last year’s return, whichever is smaller.
There’s a special rule for high-income taxpayers — meaning those with an adjusted gross income (AGI) of $150,000 or more ($75,000 for married couples filing separately).
They need to pay at least 90% of the tax they owe this year or 110% of the tax shown on last year’s return, whichever is smaller.
How to Calculate the IRS Underpayment Penalty
Calculating the underpayment penalty is complicated because, unlike other IRS penalties, it’s not a standard percentage or flat dollar amount. Instead, it’s based on:
You can use Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, as well as a worksheet from the Form 2210 Instructions to calculate your penalty. However, if you’re doing the calculation by hand rather than using tax software, be prepared to navigate some pretty complicated instructions and have a calculator ready. It’s not a matter of simply applying a percentage to your underpayment amount.
You can also have the IRS calculate the underpayment penalty for you and send you a bill.
How to Avoid an Underpayment Penalty
The easiest way to avoid an underpayment penalty is to ensure you pay at least 100% (or 110% if you qualify as a high-income taxpayer) of last year’s tax. If you owe a penalty with your 2021 return and want to avoid the same situation next filing season, you can:
1. Adjust Your Withholding
If you receive a paycheck from your employer, consider filling out a new Form W-4, Employee’s Withholding Certificate. This form tells your employer how much tax to withhold from your paycheck each pay period.
Use the IRS’s Tax Withholding Estimator to help figure out how much federal income tax to have withheld from your paycheck. Give the new Form W-4 to your company’s payroll department—don’t mail it to the IRS.
2. Make Quarterly Estimated Payments
If you’re self-employed or have significant income that isn’t subject to withholding, such as interest, dividends, and capital gains, you need to make estimated payments throughout the year.
Estimated payments are due on:
- April 15
- June 15
- September 15
- January 15 of the following year
If any of those dates fall on a weekend or holiday, the deadline shifts to the following business day. Pay close attention to those deadlines because making your estimated payments late can result in an underpayment penalty, even if you don’t owe any additional tax when you file your return.
Look at the total tax on your prior-year return, divide it by four, and pay at least that much on each estimated tax due date to avoid a penalty.
3. Use the Annualized Installment Method
If you’re self-employed or own a seasonal business, making four equal estimated payments can be difficult. For example, if you own a rafting company in Michigan, you may earn most of your income in the late spring and summer months and close up shop in the winter.
In that case, using the annualized income installment method can help you avoid an underpayment penalty.
To use this method, complete the Annualized Estimated Tax Worksheet found in IRS Publication 505 at the end of each estimated tax payment period to calculate your required payment. You’ll also need to file Form 2210, including Schedule AI, with your tax return.
Read more: How To Reach The IRS With Questions About Your Taxes
How to Remove or Reduce an Underpayment Penalty
You may be able to get the IRS to waive or reduce your underpayment penalty if:
- You or your spouse retired in the past two years after reaching age 62 or became disabled and had reasonable cause to pay your estimated taxes late. “Reasonable cause” could be a house fire or natural disaster, the death or serious illness of an immediate family member, or another unforeseen situation that made you unable to make your estimated payments on time.
- You had most of your income withheld early in the year instead of spreading it equally throughout the year.
If either of those situations applies, you can call the IRS at the toll-free number shown on your penalty notice, file Form 843 or send a letter to the address shown in the notice explaining your situation.
Just keep in mind that the IRS is currently short-staffed and working through a backlog of paper returns and correspondence. It may take a while for you to reach an IRS representative on the phone or get a response to your written request.
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