Beware: The Dangers of Underpayment Penalties That Could Cost You Big This Tax Season

Tax planning is a crucial aspect of financial management, yet it often remains underestimated by many taxpayers. One area that frequently causes confusion and potential financial strain is the management of estimated tax payments and the associated penalties for underpayment. Understanding the intricacies of estimated tax safe harbors, the requirement for payments to be made ratably, and the strategies to mitigate penalties can significantly impact a taxpayer’s financial health. This article delves into these topics, offering insights into how taxpayers can navigate these challenges effectively.

Understanding Underestimated Penalties – Underpayment penalties can catch taxpayers off guard, especially when they fail to meet the required estimated tax payments. The IRS imposes these penalties to encourage timely tax payments throughout the year, rather than a lump sum at the end. The penalty is essentially an interest charge on the amount of tax that should have been paid during the year but wasn’t. This penalty can be substantial, especially for those with fluctuating incomes or those who experience a significant increase in income without adjusting their estimated payments accordingly. While most wage-earning taxpayers have enough tax withheld from their paychecks to avoid the underpayment penalty problem, those who also have investment income or side gigs may find their withholding isn’t enough to meet the prepayment requirements to avoid a penalty.

Estimated Tax Penalty Amount – The IRS sets the interest rates for underpayment penalties each quarter.  It is equal to the federal short-term interest rate plus 3 percent. With the recent rapid rise in interest rates the underpayment interest rate for each quarter of 2024 is a whopping 8%, the highest it has been in almost two decades. Something you should be concerned about if you expect your withholding and estimated tax payments to be substantially underpaid.   

Estimated Tax Due Dates – For individuals, this involves using Form 1040-ES to make the payments, generally on a “quarterly” basis. 

The estimated tax payment schedule for individuals and certain other taxpayers is structured in a way that does not align with the even quarters of the calendar year. This is primarily due to the specific due dates set by the IRS for these payments. For 2024, the due dates for estimated tax payments are as follows:

1. First Quarter: Payment is due on April 15, 2024. This payment covers income earned from January 1 to March 31.
2. Second Quarter: Payment is due on June 17, 2024. This payment covers income earned from April 1 to May 31. Note that this period is only two months long, which contributes to the uneven nature of the quarters.
3. Third Quarter: Payment is due on September 16, 2024. This payment covers income earned from June 1 to August 31.
4. Fourth Quarter: Payment is due on January 15, 2025. This payment covers income earned in the four months of the period September 1 to December 31.

 Note, these payment due dates normally fall on the 15^th of the month. However, whenever the 15^th falls on a weekend or holiday, the due date is extended to the next business day.  

Estimated Tax Safe Harbors – To avoid underpayment penalties and having to make a projection of the expected tax for each payment period, taxpayers can rely on safe harbor rules. These rules provide a guideline for the minimum amount that must be paid to avoid penalties. Generally, taxpayers can avoid penalties if their total tax payments equal or exceed:

• 90% of the current year’s tax liability or 
• 100% of the prior year’s tax liability.

However, for higher-income taxpayers with an adjusted gross income (AGI) over $150,000, the safe harbor threshold of 100% increases to 110% of the prior year’s tax liability.

Ratable Payments Requirement – One critical aspect of estimated tax payments is the requirement for these payments to be made ratably throughout the year. This means that taxpayers should aim to make equal payments each “quarter” to avoid penalties. However, income is not always received evenly throughout the year, which can complicate this requirement. For instance, if a taxpayer receives a significant portion of their income in the latter part of the year, they may find themselves underpaid for earlier quarters, leading to penalties.

Uneven Quarters and Computing Penalties – The challenge of uneven income can be addressed by understanding how penalties are computed. The IRS calculates penalties on a quarterly basis, meaning that underpayments in one quarter cannot be offset by overpayments in a later quarter. This can be particularly problematic for those with seasonal or sporadic income. To mitigate this, taxpayers can use IRS Form 2210, which allows them to annualize their income and potentially reduce or eliminate penalties by showing that their income was not received evenly throughout the year.

Workarounds: Increasing Withholding and Retirement Plan Distributions

• Increase Withholding – One effective workaround for managing underpayment penalties is to increase withholding for the balance of the year. Unlike estimated payments, withholding is considered paid ratably throughout the year, regardless of when the tax is actually withheld. This means that increasing withholding later in the year can help cover any shortfalls from earlier quarters.
• Retirement Plan Distribution – Another strategy involves taking a substantial distribution from a retirement plan such as a 401(k) or 403(b) plan, which is subject to a mandatory 20% withholding requirement. The taxpayer can then roll the distribution back into the plan within 60 days, using other funds to make up the portion of the distribution which went to withholding. Tax withholding can also be made from a traditional IRA distribution, but this approach requires careful planning to ensure compliance with the one IRA rollover per 12-month period rule.
• Annualized Exception – For taxpayers with uneven income, the annualized exception using IRS Form 2210 can be a valuable tool. This form allows taxpayers to calculate their required estimated payments based on the actual income received during each quarter, rather than assuming equal income throughout the year. By doing so, taxpayers can potentially reduce or eliminate underpayment penalties by demonstrating that their income was not received evenly.

Managing estimated tax payments and avoiding underpayment penalties requires careful planning and a thorough understanding of IRS rules and regulations. By leveraging safe harbor provisions, understanding the requirement for ratable payments, and utilizing strategies such as increased withholding and retirement plan distributions, taxpayers can effectively navigate these challenges.

If you are expecting your pre-payment of tax to be substantially underpaid and wish to develop a strategy to avoid or mitigate underpayment penalties, please contact this office.  But if you wait too late in the year, it might not provide enough time before the end of the year to make any effective changes. 

There are special rules for qualifying farmers and fishermen, who may have different requirements and potential waivers for underpayment penalties; contact our office for details.