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Understanding the Underpayment Penalty and How to Avoid It

Royal_Mail_Revenue_Protection_StickerWhile filling out your tax return this year, 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.  This penalty is based upon the lesser of two amounts:

  • 90% of the amount of tax you will pay in total for the 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?% 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.

How To Avoid The Underpayment Penalty

Assuming that the figure you come up with is more than $1,000 in under-withholding, to pay the absolute minimum in withholding or estimated payments, subtract $1,000 from your underpayment estimate.  (Note:  you don’t have to reduce the amount of your withholding by $1,000, you can have more withheld if you wish.) Then you have three options:

Make estimated payments – on April 15, June 15, September 15, and January 15, pay 25% of the excess amount that you’ve calculated.  Postmark these amounts on or before the due date to avoid late payment penalties.

Adjust W4 withholding – for regular wages, the form is W4; for pensions, W4P; and for Social Security benefits, it’s form W4V.  Adjust the amount being withheld via this form to match your required withholding.  Make sure that if there is already tax being withheld from a particular source that you’re increasing the amount being withheld!  Too often, trying to make an adjustment to have additional money withheld, we inadvertently replace the current withholding, rather than increasing it.

Take an IRA distribution and have tax withheld from it – if you’re otherwise eligible to take an IRA distribution (either you’re age 59½ or older, or one of the other exceptions applies), when you take the distribution you have the option of having tax withheld.  By doing this, you can avoid the hassle of quarterly estimated payments, if you like.  See the article “IRA Trick – Eliminate Quarterly Estimated Tax Payments” for all the details.

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2 Comments

  1. Withholding and Social Security Benefits | Business News Online says:

    […] How much should you have withheld?  Of course, that answer is going to be different for each person.  It’s determined by how much tax you are assessed, how much withholding you have from other sources, and the shortfall in withheld (or estimated payment) tax.  You can get the details on how to calculate the proper amount of withholding or estimated tax payments in the article “Understanding the Underpayment Penalty and How to Avoid It”. […]

  2. Understanding the Underpayment Penalty and How to Avoid It | Business News Online says:

    […] Understanding the Underpayment Penalty and How to Avoid It […]