Tax Penalty for Underpayment of Tax
A tax penalty of interest is assessed on any underpayment of the tax liability, either for underwithheld taxes or for insufficient estimated tax payments.
Underpayment Tax Penalty = Short-Term Federal Rate × Tax Deficiency
Interest rates are determined by the Applicable Federal Rates, published quarterly by the IRS. Generally, these interest rates are very low compared to market rates, such as the average interest rate charged on credit card debt or even mortgages. For instance, for several years, until at least 2016, the short-term applicable federal rate was 3%.
However, there is no tax penalty if the taxpayer did not have to file a tax return for the previous year or the total tax for that year was 0. For the exception to apply, the taxpayer must be a United States (US) citizen or resident for the full tax year, which must include 12 full months.
Underpayment Penalty Safe Harbor
In determining whether a tax penalty applies for underpayment of tax, the total taxes timely paid or withheld, including any excess withholdings on Social Security or tier 1 railroad retirement payments, are summed to determine if they meet the tax liability for that period. A tax penalty will apply to any deficiency unless:
- you had no tax liability for the previous year
- your total tax liability < $1000.
- your withheld tax + paid tax + tax credits for current year
- ≥ 90% (66.67 % for farmers and fisherman) of tax liability for the current year or
- ≥ 100% of tax for previous year if adjusted gross income (AGI) ≤ $150,000 or 110% if AGI > $150,000.
- For those married filing separately, the applicable AGI limit is $75,000.
Additionally, to avoid a penalty, at least the following amounts must be paid by each payment period:
- your withheld tax + paid tax + tax credits for a payment period
- ≥ 22.5% of tax liability for the current year or
- ≥ 25% of tax for previous year if adjusted gross income (AGI) ≤ $150,000 or 27.5% if AGI > $150,000.
- The married filing separately AGI limit is $75,000.
When calculating tax liability for the current and previous year, special calculations apply when one filing was a joint return but the other was not. If each spouse filed a separate return for the previous year, then the total tax for the previous year is equal to the sum of the tax liability of each spouse. If the previous year was a joint filing, but the current year is a separate filing, then the tax liability for each spouse for the previous year is:
- calculated by determining the tax owed by each spouse as if they had filed separately, then
- multiply the tax on the joint return by the tax on one spouse calculating as filing separately divided by the total tax for both spouses calculated filing separately.
- The tax liability for the other spouse can be calculated by subtracting the total tax by the tax apportioned to the other spouse.
Example: You filed a joint return in Year 1, but in Year 2, you file a separate return. In Year 1, your joint return showed a taxable income of $49,000 and a tax of $6461. You made $41,000 of that income and your spouse earned the remaining $8000. If you and your spouse had filed separately in Year 1, then the tax on $41,000 was calculated to be $6185 and the remaining tax attributed to the $8000 income is $803, yielding a total tax of $6988. Therefore, the percentage attributed to you would be equal to $6461 × $6185 ÷ $6988 = $6461 × 88.51% = $5719. The amount attributed to your spouse would be equal to $6461 – $5719 = $742. These are the amounts that would be used to compare the 2 years when determining whether a penalty will apply for underpayment.
Any underpayment for an installment cannot be made up by later overpayments unless the amount was withheld, since withheld amounts are divided evenly among the pay periods, although the taxpayer can choose a different allocation, if desired. If a joint return was filed for either the current tax year or the previous year, then the tax liability of each spouse will be determined by a percentage, equal to the taxes owed if a spouse filed separately divided by the total amount of tax owed by both spouses if both filed separately.
The taxpayer can either calculate the penalty on Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts or have the IRS figure it. However, the taxpayer will have to use Form 2210 if:
- the taxpayer requests a waiver of the penalty, which must include grounds for the waiver;
- the taxpayer elects to use the annualized income method in Schedule AI of Form 2210; or
- the taxpayer chooses to allocate withholdings to the time period in which they were withheld rather than having the entire withheld amount allocated equally over the payment periods.
The underpayment penalty can be waived if:
- the taxpayer did not pay because of a casualty, disaster, or other such circumstance, or
- the taxpayer either became disabled or retired after reaching age 62.
If the waiver is being requested because of a disaster or other similar circumstances, then the taxpayer should attach documented evidence of the event, such as police and insurance reports, and why the event prevented the tax payments. However, if the taxpayer lived in a federally declared disaster area, then the penalty may be waived automatically.
You can use the short method to calculate the penalty in Part III of Form 2210 if you either made no estimated tax payments for the tax year or paid the same amount for each of the 4 payments by their due date.
The regular method in Part IV must be used if:
- at least one estimated tax payment was paid after the due date
- less than 4 installments of estimated tax was paid
- the payments were unequal
- the annualized income installment method was used; or
- the payments were calculated based on the amount of withheld tax for each payment period.