Guide to Underpayment Penalties

By Timothy Moore. January 27, 2025 · 9 minute read

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Guide to Underpayment Penalties

Taxpayers can incur an underpayment penalty from the Internal Revenue Service (IRS) if they don’t pay enough in taxes in a given year. Because federal taxes operate as a pay-as-you-go system, taxpayers must keep up with what they owe Uncle Sam.
You may not think about paying your taxes as you go because you have a full-time job and your employer withholds taxes from your paycheck. But changes in your income or status can trigger different tax rates, and if you are self-employed or earn any freelance income, you may need to pay quarterly estimated taxes to avoid underpaying.

Key Points

•   Underpayment penalties apply when insufficient taxes are paid during the year.

•   These penalties owed to the Internal Revenue Service, along with interest, accumulate over time.

•   Avoiding penalties is possible by paying 90% of the current year’s tax or 100% of the previous year’s.

•   The IRS may waive penalties for specific life events like retirement, disability, or unforeseen circumstances.

•   If the penalty is unaffordable at the moment, payment plans are an option.

What Is an Underpayment Penalty?

An underpayment penalty is a fee that taxpayers can incur if they do not properly pay their taxes throughout the year. If you’re charged an underpayment penalty by the IRS, you not only have to pay your taxes but this additional fee and interest on the amount owed.
The IRS officially calls this the IRS Underpayment of Estimated Tax Penalty — and it can be a significant problem for taxpayers who don’t keep up with their quarterly payments.

How Does the IRS Underpayment Penalty Work?

Nobody likes paying taxes and dipping into their savings account to do so, but underpayment penalties can make the experience even more expensive. Here’s a breakdown how this penalty works — so you can focus on avoiding it.

Paying Estimated Taxes

The IRS requires taxpayers to pay their taxes as they go. If your employer is (correctly) withholding funds from your paycheck, you’re probably paying enough not to worry about incurring this penalty. (However, it can be wise to check in with how you are tracking as you prepare for tax season.)

But if you have additional income — capital gains or self-employment income, for example — it’s important to make sure you’re paying the government as you go. Unfortunately, there’s no employer withholding taxes in this scenario, so you’ll need to make quarterly payments yourself.

Quarterly tax deadlines are typically as follows, though the dates may vary slightly depending on when weekends and holidays fall in a given year:

•   April 15 for income earned between Jan. 1 and March 31

•   June 15 for income earned between April 1 and June 30

•   Sept. 15 for income earned between June 1 and August 31

•   Jan. 15 of the following year for income earned between September 1 and December 31

To avoid the penalty, you need to pay at least 90% of your tax liability each quarter. But without sitting down and doing the math each and every quarter, it can be challenging to calculate how much you’ll owe, especially if your income isn’t steady throughout the year.

That’s why the IRS has the safe harbor rule. Instead of paying 90% of this year’s tax liability, you can pay 100% of last year’s tax liability, spread evenly over the four quarters. Because you should already know this number from the previous tax season, you won’t need to do any estimating.

The 100% of last year’s tax liability applies to most, but not all, taxpayers. Taxpayers who made more than $75,000 ($150,000 if filing jointly) in the previous year must pay 110%, not 100%, of last year’s tax liability.

Note: You will not incur an underpayment penalty if you owe less than $1,000 to the IRS after factoring in all withholdings and tax credits. Farmers and fishermen have special rules governing how much they must prepay.

Recommended: Different Types of Taxes

Knowing If You Owe a Penalty

So how do you know if you’ve incurred an underpayment penalty? The IRS will inform you. Keep an eye out for an official notice in the mail.

That means you won’t be notified about your underpayment penalty until after you’ve filed your taxes. The IRS will analyze what you actually owed and what you paid over the course of the previous year. With that information, the IRS can correctly calculate your penalty and interest.

You can also use Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts to determine if you’ll owe a penalty. A personal accountant should be able to help you navigate this process.

A professional’s services may be especially valuable if you are filling out your taxes for the first time as a freelancer or are early in your experience as a taxpayer.

How Much Is a Typical Underpayment Penalty?

Wondering how much an IRS underpayment penalty costs? The frustrating answer: It depends. You can use Form 2210 to calculate how much you owe, but it’s a complicated process; you could be better off waiting for a bill from the IRS.

Several factors impact the total cost of your underpayment penalty, including:

•   The amount by which you underpaid

•   When the payment was due each quarter and how much you underpaid by in each quarter

•   The interest rate, which changes each quarter

For example, you’ll owe a late penalty for each month you’ve underpaid. And then you’ll have to calculate interest due on that penalty based on the IRS’s published interest rates. (For the first quarter of 2023, it’s 7%.)

Recommended: Form 1099, Explained

Can Underpayment Penalties Be Removed?

It’s difficult — but not impossible — to have underpayment penalties removed. Here are a few specific instances in which the IRS says it may waive the penalty:

•   Recent retirement: If you or your spouse retired in the last two years after turning 62 or became disabled and you have a reasonable cause (determined by the IRS) to have underpaid, the IRS may reduce the penalty.

•   No tax liability: If you didn’t have any tax liability in the previous tax year, the IRS may waive your penalty.

•   An error by the IRS: If you can prove that the IRS gave you incorrect advice that resulted in an underpayment, you may qualify for penalty relief.

•   Variable income: If your income is a roller coaster throughout the year, it can be more challenging to estimate — and afford — quarterly tax payments. You can fill out Form 2210, Schedule AI, Annualized Income Installment Method to potentially avoid the penalty.

•   Disaster: If you can prove some unforeseen calamity put you in a position where it became impossible to make estimated tax payments, the IRS may waive the penalty.

Recommended: Most Tax-Friendly States to Retire In

Tips for Avoiding Underpayment Penalties

Underpayment penalties can be a real drain on your bank account — but they’re completely avoidable. Here are a few ways you can avoid underpayment penalties from the IRS:

1.   Increasing withholdings: If you’re concerned that you’ll owe more than $1,000 when you file your taxes, you may want to increase your withholdings with your employer by filling out a W-4. Overpaying via withholdings can also be helpful if you have minor sources of income outside of work, as the overpayments from your paycheck may cover what you’d owe from that other revenue.

2.   Paying quarterly taxes on time: If you can’t have taxes withheld from a paycheck, you’ll need to pay estimated taxes every quarter. Because it can be difficult to calculate exactly what you owe each quarter without sitting down and doing some serious math, you can take advantage of the IRS’s safe harbor rule. As long as you pay 100% (or 110% if you’re a high-income taxpayer) of last year’s tax liability spread evenly over four quarters, you should be able to avoid a penalty for underpayment. Following this practice can be part of good money management.

3.   Using the Annualized Estimated Tax Worksheet: Self-employed individuals who don’t make a steady income — like a shop owner whose revenue doubles during the holidays or a lawn maintenance contractor who has higher demand in the summer — can fill out the Annualized Estimated Tax Worksheet (IRS Publication 505) at the end of each quarter. This enables such taxpayers to accurately calculate what they owe based on what they made that quarter, rather than a flat quarterly estimate.

4.   Applying for a payment plan: If you truly can’t afford to pay the full amount of taxes you owe from your checking account, you can apply for a payment plan with the IRS. Doing so may help you avoid additional penalties.

You can investigate different ways to raise funds, whether that means tapping your emergency fund or seeing if you can pay taxes with a credit card.

The Takeaway

You may owe an underpayment penalty if you did not correctly have your taxes withheld or make estimated quarterly payments to the IRS. While no one wants to owe more money to the IRS, it’s important to pay taxes in a timely manner, as this penalty also accrues interest.

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FAQ

Do underpayment penalties affect your credit?

An underpayment penalty by itself cannot affect your credit score. If, however, the IRS files a Notice of Federal Tax Lien in court, you can expect your credit score to take a hit — but the IRS typically only does this in scenarios in which you owe a lot of money. And at that point, you have more to worry about than your credit score, as the IRS can make claims to your assets, like your house and car.

How do you calculate an underpayment penalty?

To calculate an underpayment penalty, you’ll need to use IRS Form 2210. The math can be complicated, and interest rates change from quarter to quarter, so it may make sense to work with an accountant. Otherwise, you can wait for the IRS to send you a bill.

What happens if you cannot afford to pay an underpayment penalty?

If you cannot afford to pay an underpayment penalty, the IRS advises that you pay what you can now and then apply for a payment plan. This may help you avoid more penalties.

Do underpayment penalties accrue over time?

Underpayment penalties accrue interest over time. The longer you go without paying your taxes to the government, the more you’ll owe in interest on top of the underpayment penalty.


Photo credit: iStock/fermate

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