An underpayment penalty is a fine levied by the Internal Revenue Service (IRS) on taxpayers who don’t pay enough of their estimated taxes, don’t have enough withheld from their wages, or pay late. To avoid an underpayment penalty, individuals generally must pay at minimum either 100% of last year’s tax or 90% of this year’s tax.
Learn how underpayment penalties work and more about how you can avoid them.
Key Takeaways
- An underpayment penalty is a fine levied by the Internal Revenue Service (IRS) on taxpayers who don’t pay enough tax during the year through withholding and/or their estimated taxes, or who pay late.
- To avoid an underpayment penalty, individuals generally must pay the lesser of 100% of last year’s tax or 90% of this year’s tax.
- If your adjusted gross income (AGI) for last year exceeded $150,000, you must pay the lesser of 110% of last year’s tax or 90% of this year’s tax.
- Typically, underpayment penalties are 5% of the underpaid amount, and they’re capped at 25%.
- Underpaid taxes also accrue interest at a rate that the IRS sets annually.
What Is an Underpayment Penalty?
A tax penalty is imposed on individual or corporate taxpayers for not paying enough of their total estimated tax and withholding due. Taxpayers should consult IRS Form 2210 to determine if they are required to report an underpayment and pay a penalty.
How Underpayment Penalties Work
The tax law requires that taxpayers make payments as they realize income throughout the year through withholding, estimated taxes, or both. To avoid an underpayment penalty, individuals whose adjusted gross income (AGI) is $150,000 or less must pay the lesser of 90% of the current year’s tax or 100% of last year’s tax, by combining estimated and withholding taxes. Individuals whose AGI for the preceding taxable year exceeds $150,000 must pay the lesser of 90% of the tax due for the current year tax or 110% of the tax on the individual’s return for the prior taxable year.
The underpayment penalty is owed when a taxpayer underpays the estimated taxes or makes uneven payments during the tax year that do not correspond adequately to the taxpayer’s current income for a period. Taxpayers with self-employment income should take their liability for Social Security and Medicare taxes into account when calculating the amounts due.
Some taxpayers, such as sole proprietors, partners, and S corporation shareholders, must pay taxes in four equal payments during the year. In some cases, taxpayers who receive their income unevenly may be able to pay different amounts quarterly. Taxpayers should use IRS Form 2210 to determine if their payments of withholding and estimated taxes during the year are sufficient to avoid a penalty.
If taxpayers realize that they have underpaid, they must pay the difference—plus a penalty that is calculated based on the outstanding amount owed and how long the amount has been overdue. The penalty is not a static percentage or flat dollar amount. It’s based on several things, including the total underpayment amountand the period in which taxes were underpaid. Underpayments are subject to the failure-to-pay penalty, which is 0.5% of the amount owed for each month and the part of a month for which the tax is not paid.
The underpayment failure-to-pay penalty can’t be more than 25% of the unpaid amount.
Interest Payments
Along with a penalty, tax underpayments (or overpayments) accrue interest. The IRS determines the interest rate every quarter, generally basing it on the federal short-term rate, plus 3 percentage points, for most individual taxpayers.
For the fourth quarter (Q4) of 2022, the rates were:
- 6% for individual underpayments
- 8% for large corporate underpayments (exceeding $100,000)
For the first quarter of 2023, the announced rates are 7% for individual underpayments, and 9% for large corporate underpayments.
Example of Underpayment Penalty
For example, if you owed $5,000 in taxes for the year, but only paid $2,000, you would have underpaid your taxes by $3,000.
Because the amount is more than $1,000 and you did not pay at least 90% of what you owed, you would be subject to an underpayment penalty (unless you met other criteria for avoiding it). The penalty would be the federal short-term rate plus 3 percentage points. For Q4 2022, that rate was 6%, or $180.
How to Avoid an Underpayment Penalty
The best way to avoid an underpayment penalty is to take steps to ensure that your tax obligations are fully paid on time.
You can also avoid the underpayment penalty if:
- Your tax return shows you owe less than $1,000
- You paid 90% or more of the tax that you owed for the taxable year or 100% of the tax that you owed for the year prior, whichever amount is less
The underpayment penalty may also be waived by the IRS under several other scenarios, including:
- The taxpayer was a U.S. citizen or resident for the preceding tax year and did not owe any taxes for that year
- The taxpayer missed a required payment because of a casualty event, disaster, or other unusual circ*mstance
- The underpayment was a result of reasonable cause and not willful neglect
- The taxpayer retired after reaching age 62 during the current or preceding tax year
- The taxpayer became disabled during the tax year for which estimated payments were owed or during the preceding tax year
Special Considerations
If you do not qualify for the exceptions to the underpayment penalty, you may qualify for a reduced underpayment penalty in some situations. For example, an individual who changes their tax filing status from single to married filing jointly may get a reduced penalty due to the larger standard deduction.
A reduction might also be extended to taxpayers who generatesignificant portions of their income late in the calendar year. One such example is an investment holding that’s sold in December, triggering a substantial capital gains tax.
What Were the Underpayment Penalties for 2022?
For the fourth quarter (Q4) of 2022, Internal Revenue Service (IRS) underpayment penalties were 6% for individual underpayments and 8% for large corporate underpayments over $100,000. Underpayment penalties are the federal short-term rate plus 3 percentage points.
What Are the Underpayment Penalties for 2023?
For the first quarter (Q1) of 2023, the IRS underpayment penalties are 7% for most underpayments and 9% for large corporate underpayments.
What Are IRS "Safe Harbor" Rules?
“Safe harbor” rules allow you to not pay a penalty or to pay a reduced penalty if you meet certain conditions. An underpayment penalty with the IRS can be avoided if you meet conditions like owing less than $1,000 or paying more than 90% of your tax obligation for the year.
Can You Make Estimated Tax Payments All at Once?
Some taxpayers, such as sole proprietors, partners, and S corporation shareholders, must pay taxes quarterly if they will owe more than $1,000. Their payments are called estimated tax payments. You cannot pay estimated tax payments all at once. You must pay them each quarter.
The Bottom Line
If you don't pay enough taxes—estimated taxes, tax withholding, or taxes due—you could end up paying an underpayment penalty. If you're charged a penalty, check to see if you qualify for an exemption or reduced penalty. But the best way to avoid underpayment penalties is to be sure that you figure estimated taxes correctly and pay your taxes on time.
