Guard Against An IRS Underpayment Penalty

If you pulled in more money than you’re used to making — especially if it came from untaxed work — you could be facing a higher-than-expected tax bill that will grow even higher due to a prepayment penalty of 3 or 4 percent if you owe more than $1,000. There’s not much you can do to avoid the penalty for your 2011 taxes, but you can take steps to avoid it next time.

Thousandaire tells you what to do:

* Pay quarterly taxes. If you owed a lot of money last year and expect to rake in the same amount this year, divide your tax bill by four and send regular payments to the IRS.

* Increase your tax withholdings. If you’ve gotten a colossal raise or bonus, your old withholding amount may no longer cut it. Check with your human resources department to up the amount that’s withheld from your paycheck. Also consider upping your retirement contributions.

How to Avoid The Underpayment Penalty [Thousandaire]

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  1. floydfan says:

    Captain Obvious again.

    • Mr. Fix-It says: "Canadian Bacon is best bacon!" says:

      If you keep commenting on Phil’s articles, you’re going to be using that phrase a lot.

    • huadpe says:

      No, it’s not obvious.

      Many people do not realize that if you end up owing taxes at year end, you may face a penalty above and beyond the taxes owed for not having paid them during the year. It’s good information to have, and the summary is actually pretty clear, which is tough for tax-related issues.

      I know about these issues quite well (and pay quarterly on a 1040ES), but that doesn’t mean they’re obvious. I didn’t know about them til the first time I got hit with a penalty (fortunately the penalty was only $3, but still).

    • AcctbyDay says:

      Not that obvious, no. I have many taxpayers come to my firm owing much money for not making quarterly payments. This is a common problem for people who have never made quarterly payments or needed to make them before. This usually results when someone goes from being a W2 employee to contract labor.

      • FatLynn says:

        I’m set up to make quarterly payments for the first time, but I get paid about 6 weeks after I invoice. I believe that I have to recognize the income in the quarter I earned it, but I can’t find any rule to that effect, and fronting the cash is not the best situation.

        • DemosCat says:

          Disclaimer: I am not an accountant

          I believe it’s a matter of you picking an accounting method that works for you – cash or accrual – declaring which way you handle your books, then sticking to the plan.

          If you use the accrual method, then yes you have to treat income as earned in the quarter you bill for it (accounts receivable), and if necessary borrow the money to make your quarterly tax payment.

          And obviously, if you use the cash method, you report income based on when you actually receive payment.

          But the underlying point is, you get to pick your accounting method, this is not dictated by the IRS. That said, what the IRS does not allow is switching back and forth in accounting methods just to try to take advantage of a particular situation.

    • bee8boo8bop8 says:

      Actually, this is the first year my husband has made so much freelancing that this is a concern for us. I didn’t know I had to pay a penalty because we owe more than $1000. I appreciate the info; I was already going to have to amend our return and I’ll look into this.

      • eeelaine says:

        You may not have to pay a penalty if your income is significantly greater than last year – make sure you (or your tax preparer) goes over the penalty abatement forms.

    • TasteyCat says:

      My first year of filing a Schedule C, I had no clue about quarterly tax payments going into it. During the year, I did happen to read about it, but it was new advice to me. I figured I could just pay all at once in April, which ultimately is more difficult to manage anyway. Now it’s obvious to me, but it was not back then.

  2. bkeyport says:

    Note however, that as with all tax articles on consumerist or other websites, this is woefully incomplete.

    Correct information would include that you will likely not incur a penalty next year if your increase in pay is from a taxed income. The withholding you hold now will cover it if it covered it before.

    The exception is the multi-job/multi-worker situation. Any time you have multiple W-2′s in play on the tax return, and one or more is a significant less income than the others, you’ll have tax problems in the mix.

    I would always recommend that if you’re dealing with multiple W-2s, that you see a professional YEAR ROUND tax accountant,.

    • KommonCentz says:

      THIS.
      Switched jobs in April. Company switched payroll company in June. My withholding got all screwed up, with the last company processing me in a different tax bracket and assuming that my income from June-Dec was my whole year’s income. Result? I owe. Previous years I had been getting a high 4 figure return…

    • DrPizza says:

      In many such cases, it’s cheaper to overpay your taxes and get a larger return than to pay an accountant to figure out out so that your return is close to zero. Interest on savings is generally 1% or less these days. On a $1000 return, that means you miss out on 5 or 6 dollars in interest. (You would only have an average balance of 500 over the course of the year.) You would have to overpay by over $8000 before you would hit anywhere near missing out on $50 in savings account interest. Can you find an accountant who will do the work for you for less than $50??

      Unless you absolutely have no room to save money in your budget, then this (overpaying), for many people, is often the easiest, cheapest solution. (Though, hopefully you can come within $1000 on your own.)

  3. CubeRat says:

    Concerning any penalty….ask the IRS to calculate it and bill you instead of having a ‘tax professional’ do it.

    My father sold property (he was in his 80s) and thought he paid enough taxes; he didn’t. He had the taxes done by a CPA that was very highly rated and recommended to him. The CPA did everything correctly, but insisted that my father pay the 26k penalty. I told my father to file and ask the IRS to calculate and ask for a waiver as this was a honest error. He did as the CPA suggested. I contacted the IRS and sent a letter explaining the circumstances, with back up documentation. The IRS agreed and waived the penalty and returned the 26k to my father. He still owed the additional tax and some interest, but they agreed the penalty was not justified in this case.

    • Bsamm09 says:

      That’s a pretty bad CPA IMO. I calculate penalties and interest to allow the client to get an idea but tell the client to pay the liability only and let the IRS calculate it. Then I can see exactly how they did it and if I disagree, I can write a letter stating my case.

      Had one that we fought for almost two years but in the end we won but it should have been much sooner. It was over the rate the capital gains were calculated. I don’t even think an actual person looked at it as it was obviously a mistake on their part. Finally had to write the tax payer advocate and they solved it quickly.

  4. Shaun5 says:

    This isn’t a hard and fast rule. You can owe more than $1,000 and NOT face a penalty provided you A) Have paid at least 90% of your total tax bill or B) paid an amount equal to 100% of your total tax from the previous year, whichever is smaller. http://www.irs.gov/taxtopics/tc306.html

    • bee8boo8bop8 says:

      Thank you for this; duly bookmarked.

    • fatediesel says:

      Yes, I owed over $1,500 this year in federal but did not owe any penalties or interest because I had withheld over 100% of my prior year’s total tax.

    • DemosCat says:

      Thank you! I was going to post this exact point, but you beat me to it. Phil, are you paying attention?

      I had one year where I owed over $2000 in taxes to the IRS due to an unanticipated windfall. But, since my withholdings that year were greater than the taxes owed the prior year, no penalty!

      And it doesn’t matter if the source of that extra income is earned from another payroll job, from self-employment, interest from cashing a bunch of savings bonds your grandmother bought for you 25 years ago. As long as the amount paid in is at least the lessor of 100% of the prior year’s tax owed, or 90% for this year, there is no penalty.

  5. Extended-Warranty says:

    In my personal experience, you can’t help these kind of people. It’s “never their fault” they underpaid, and they “can’t afford” to change withholding.

    • Nikephoros says:

      I love the “can’t afford to increase my withholding” line. I get that from my clients every single day. It is neither the IRS’ nor the American taxpayer’s job to subsidize your lifestyle. If your income isn’t sufficient to pay your taxes and personal expenses (in that order) it’s time to consider seeking a new method of income, or reducing the personal expenses.

  6. SmokeyBacon says:

    I had never heard of this until after my father died and I did end up owing more in taxes then I could have ever guessed, because of my own stupidity and because I trusted the people I was dealing with. I didn’t think to talk to an accountant until I actually had to file the taxes and found out that I owed a lot more, and that because of that there was a penalty. Because of the situation (it wasn’t due to additional work income and was not expected) he was able to have them waive the penalty, so if this happens to you be sure to see if they can do it. It was a one time thing for me so I think they understood and allowed it – I was very glad I had that accountant to fight for me on that one (and it is why he is still my accountant today).

  7. mannyvel says:

    Of course, if you can beat the 3/4% fee by investing your estimated tax you should consider it.

  8. AllanG54 says:

    If you get a raise your taxes go up along with it. The withholding tables change as one gets into a higher bracket so if you’re claiming single and zero dependents there’s nothing to change so that part of the post makes little sense. Sending estimates is very important if you’re self employed or collect a lot of income that’s untaxed (dividends, interest) but it would have to be a huge amount because the IRS won’t penalize you if you pay 90% of what your tax is throughout the year if it’s deducted from your paycheck.

  9. nearly_blind says:

    I don’t like summary and the original blogger article.

    The IRS penalty, is really the interest on the the quarterly estimated tax payments you should have made. The 2011 annual rates were 3 or 4% depending on the specific quarter.

    The 1st point to make is your basically getting a 3 or 4% loan if you underpay and have to pay this interest. This is not a bad deal if underpaying allows you to pay off higher interest debt or earn a better return elsewhere, assuming of course you can pay the IRS in April. This is true even if you have to borrow more money the next April to pay the bill, as long as the rate is not worse than the debt you paid off.

    The 2nd point is that the penalty/interest is NOT that rate (e.g. 3 or 4%) times the amount you owe. It is less than this, because the interest is computed based on each estimated tax quarterly due date and amount that would have been due if you paid them. The quarterly dates are 4/15, 6/15, 9/15, 1/15. If you do the 5th grade math the average period of your “loan” is 8 months not one year, so your “Penalty” is 2/3 times the published rate (if it was the same each quarter). So the bloggers example is bogus.

  10. eeelaine says:

    Once again, an article that has misleading or inaccurate financial information. You will likely not be subject to a penalty if you make significantly more than in the previous year, or if you got a bunch of income towards the end of the year.

    PHIL – for the love of jeebus, do some fact checking before posting blurbs and a link to a random blog.

  11. Yorick says:

    Why does all this IRS and tax return advice start cropping up when it’s days before the deadline, instead of like in January when it would actually be useful to those of us who are responsible enough to take care of it right away? Or useful at all, since a lot of these things are tasks one would have to do months in advance or even last year?

  12. BrianneG says:

    I wanted to send quarterly payments, but I just couldn’t figure out how to do it online. I need to increase my withholdings this year to make up for having a second job but we talked it out with the CPA when doing our 2011 taxes. For 2012, we’ll be subject to the AMT for the first time ever.

    Everyone should double check the AMT because I don’t think withholdings can take it into account.