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Come April 15th will you owe a penalty for underpayment of taxes? If you are like most people, you won’t know the answer until you file your taxes. The IRS may add a penalty for underpayment if you owe $1,000 or more in taxes when you file your return.
If all or most of your income is earned from wages, you should have no worries. If your withholdings are correct on your paycheck, your employer will have withheld enough money to keep you comfortably out of the penalty range. Those of you who make substantial money from investments or self-employment are the ones who should concern themselves with the penalty rules.
What to Do If You Owe More than $1,000
If you owe $1,000 or more in addition to the taxes you already paid the IRS during the year, you may or may not owe a penalty. To determine if you owe a penalty, you will need last year’s tax return. Look at the amount of federal income tax you already paid in for this year and compare it to your total federal income tax bill last year. If you paid in at least as much as you owed last year, you are okay. If not, you still may be okay if you paid in at least 90% of your total tax liability for this year (Note: This rule is different for high-income taxpayers. The definition of “high income” changes each year, so if you have income around $150,000 or more - $75,000 if married filing separately - consult your tax advisor).
To explain further, let’s look at an example. In 1999 you paid $15,000 in federal income tax. In 2000, you owe a total of $20,000 in taxes. You paid only $17,000 in taxes, so owe the IRS $3,000 more. Do you owe a penalty? The answer is “no”, because you paid in more taxes during 2000 than you owed in 1999.
Let us change the scenario a little bit. You still paid $15,000 in 1999, but your 2000 total tax was $13,000. You paid in $11,800 during the year. In this example you still do not owe a penalty, but for a different reason. You did not pay in as much as you owed in 1999. But, you did pay more than 90% of your total tax liability (90% of $13,000 is $11,700).
By changing the second scenario just a bit, you will owe a penalty for underpayment. If you paid in $11,600 instead of $11,800, then you fall below the 90% threshold and will owe a penalty. The IRS will access a penalty on $1,200 – the amount of the shortfall.
If you do owe a penalty, the IRS will figure it for you if you would like. It is likely, however, that by the time they notify you of the penalty additional charges will have occurred. It is best to be proactive and pay the penalty on time. If, along with your tax advisor, you have determined that you owe a tax penalty for underpayment, it can be entered on your Form 1040 and paid when you file your tax return. As long as you pay before your tax return is due, the penalty will not increase. Sometimes you will also be required to submit Form 2210, Underpayment of Estimated Tax, with your return. If you are not required to file the form, it is very handy to complete it anyway to keep with your tax records.
How to Avoid a Penalty Next Year
If you expect to owe taxes outside of wages from an employer next year, you can do one of two things:
1. If your self-employment or investment earnings are expected to be minimal, give your employer a new W-4 with additional withholding allowances. More taxes will then be withheld from your pay.
2. If this will not work for you, then making estimated tax payments is an excellent idea. By filing form 1040-ES and making estimated tax payments quarterly throughout the year, you can avoid underpayment penalties by keeping your taxes current.
To determine your estimated tax you will need the Tax Rate Schedules for next year. The IRS develops these abbreviated schedules for use in estimated tax computations. You should be able to get them from the IRS web site, from your tax advisor, or by contacting the IRS directly. Once you have the tax schedules, first estimate your taxable income next year. This computation can be quite long. Professional tax preparers often have worksheets to make this step easier. Find your total tax liability from the Tax Rate Schedules, and then subtract the amount your employer will withhold from your pay. The remaining balance is the total amount of your estimated payments.
The IRS likes you to pay taxes on income as you receive that income. By default, the IRS assumes you earn your income evenly throughout the year. If you do not earn the income equally, there are procedures to notify the IRS and pay your taxes in uneven installments. Generally, though, you will pay your estimated taxes in four equal installments throughout the year. On the due date of the first installment, April 15, file form 1040-ES along with a tax voucher. Then, on subsequent estimated tax due dates – June 15, September 15, and January 15 – submit additional vouchers with payments. You may, of course, pay the entire estimated tax for the year with your first payment or pay the balance at any time. For details on making estimated payments consult the IRS or a tax expert about your unique situation.
As with most tax rules, there are exceptions and some definitions are less than intuitive. If you think you may owe a penalty for underpayment or want to avoid future penalties, consult the IRS or meet with your tax advisor. IRS Publication 17 also gives a good overview of these and other tax rules.
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