As a financial advisor, I look at a lot of tax returns. I’m usually looking for key tax information that guides long-term tax planning. But, something that I’ve noticed is an uptick in people owing an underpayment penalty to the IRS.
I’m not sure what is causing the increase – a byproduct of the recent tax changes? – but if it’s impacting you there are a few ways that you can avoid the penalty and save yourself a few hundred dollars.
What is it, how does it happen, and am I paying?
You owe an underpayment penalty if you didn’t pay enough taxes throughout the year. This can happen even if you are a salaried employee.
Most of the time, employees have taxes withheld from their paychecks and the employer sends them to the IRS. But if you claim the wrong number of allowances on your W-4 you could end up underpaying.
Also, if you a regular employee and have income from other sources you could also be underpaying.
It’s even easier to underpay if you’re self-employed, a freelance worker, or retired. You don’t have taxes withheld as you earn income. You’re required to make estimated quarterly payments based on what you earn, which can be variable. This makes it easy to miscalculate the taxes owed or even skip a payment on accident.
You’ll be able to tell if you’re paying an underpayment penalty by looking at line 24 on page 2 of Form 1040. If there is a number there, it’s likey from an underpayment of taxes.
How to avoid it
Generally, most people will avoid the penalty if they:
- owe less than $1,000 in tax after subtracting their withholdings and credits
- had no tax liability the previous year
- paid at least 90% of the tax for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller
- for high-earners, it’s 90% of the current year or 110% of the prior year, whichever is smaller
The penalty may be waived if either:
- you experienced an event, like a natural disaster, that caused the underpayment or,
- you are retired (after reaching age 62) or became disabled during and the underpayment was due to reasonable cause, not willful neglect
You’ll have to submit the request for the waiver in writing when you submit your tax return.
If none of the above apply to you, you can’t undo what’s done. You’re stuck with an underpayment penalty but you can take steps to avoid one going forward.
If you’re a regular worker, start by increasing your withholdings on your W-4 so that more tax is taken out of each paycheck. Here is a link to the IRS’s tax withholding calculator to help you determine the amount, https://www.irs.gov/individuals/tax-withholding-estimator
If you’re a worker with income from outside sources, also consider increasing your W-4 withholdings, or make estimated tax payments to cover your taxes. I think that having the amount withheld from your paycheck is much easier than writing quarterly checks to the IRS.
If you’re self-employed, a freelancer, or retired be sure to make your estimated payments for the current tax year by the deadlines. I recommend setting up an automatic monthly transfer from your checking (or business checking) into a separate account that’s earmarked for your estimated payments. That can help you avoid a cash squeeze when it’s time to send the checks in.
If you’re retired and have IRAs, you can more taxes withheld from each distribution from you IRA. This works especially well if you are taking required minimum distributions (RMDs) but don’t need the income.