Avoiding the Underpayment Penalty with Form 2210 – Annualized Income

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In another article I covered a few ways that you might avoid an underpayment penalty in certain circumstances. Specifically, when you had not had the right amount of money withheld throughout the year or had not made timely estimated payments. But what if your income was uneven, sporadic throughout the year, and you received a good deal of your income in the last month? There’s a potential for an underpayment penalty with this sort of income, but there’s also a systematic way to avoid it. (H/T to reader P.D. for the suggestion!)

Self employment income

Generally this situation comes about when you’re either self-employed or work on a contract basis, and you’re generally responsible for making regular estimated tax payments on your income. You might also have sporadic income if you have a side-hustle or you sell some appreciated item (where the income from the sale becomes taxable). In other words, your income, or at least part of it, is not coming to you in the form of a paycheck from an employer, where the employer is withholding taxes for you.

When you’re in this position, typically you’ll make estimated tax payments throughout the year – one by April 15, for income earned through March; one by June 15 for income earned through May; one by September 15 for income earned through August; and lastly one by January 15 for the income earned through December. 

When it comes time to file your taxes (by April 15 of the following year), if the four payments you made through the year are not roughly equivalent to 1/4, 5/12, 8/12 and 100% (respectively) of your annualized income throughout the year, the IRS might say that you’ve underpaid estimated taxes. However, if you made these payments based on the actual net income that you received during the period, you have no reason to be concerned, as long as the payments were adequate for the income received.

Form 2210

There’s an IRS form, Form 2210, that is ostensibly used to determine the amount of underpayment penalty that applies to you, if any. In addition, Form 2210 provides you with a way to show that your income was not received evenly through the year, and that you made payments based on the actual taxable income during each period, if that’s the case.

At the bottom of Form 2210 is Schedule AI – Annualized Income Installment Method. This Schedule provides you with the format to report your actual income during those four periods mentioned previously: through the end of March, then May, then August, and December. In addition, you’ll report in Schedule AI the amounts that you have paid in estimated taxes.

You’ll also need detail information about your other income throughout the year, such as if you had a “regular” job with a paycheck and withheld taxes, plus interest and dividends from investments, and any other income that you earned (rent, royalties, side-hustles, etc.).

Filling out Schedule AI provides a way to show the IRS that you did make the payments correctly (assuming that you did) in correspondence with the income as you earned it. You’ll then work your results from Schedule AI into Part IV of Form 2210, and complete the process to determine if you have an underpayment penalty. This form, if necessary, is filed along with your Form 1040 for the year.

But what if you didn’t make the payments correctly?

Here’s another way that Schedule AI can help you out, especially if you haven’t been very accurate in your estimated tax payments. Let’s say, for example, you miscalculated (or just out-right didn’t pay the necessary amount) for the first payment in April, but then you corrected it and “caught up” with the June payment. Using Schedule AI can ensure that your penalty for underpayment only applies until you made the “catch up” payment. 

Then, if you made the appropriate payments through the rest of the year to correspond with your income during those periods, no further underpayment penalty would apply.

Otherwise, you might get stuck with underpayment penalties that could apply across the entire year, resulting in a considerably higher penalty.

If you didn’t make the proper payments throughout the year and you’re looking at a big underpayment penalty, you might look at the options presented in the article Understanding the Underpayment Penalty and How to Avoid It, as mentioned earlier.