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Estimated tax penalties skyrocket!!

The United States has a “pay as you go” tax system in which payments for income tax (and, where applicable, Social Security and Medicare taxes) must be made to the IRS throughout the year as income is earned, whether through withholding, by making estimated tax payments, or both. Individuals and corporations that underpay their taxes during the year are assessed estimated tax penalties by the IRS.

In past years, the penalty for failing to make estimated tax payments was minimal. Therefore, many taxpayers opted to just pay the penalty rather than hassle figuring out what they owed for the particular quarterly payment, and then make it.  Well, that strategy is now out the window since with the inflation caused high interest rates, it is not a viable option at this time.  It is a lot of money thrown away and flushed down the porcelain basin when taxpayers incur this penalty!

The estimated tax penalty (also called the “underpayment penalty”) is calculated separately for each quarter based on the amount of unpaid tax for that quarter. The penalty equals the federal short-term interest rate (in the first month of the quarter in which taxes were not paid) plus 3 percent.

The federal short-term interest rate changes from time to time based on interest rates generally. Thus, the estimated tax penalty amount changes as well. For many years, while inflation and interest rates were low, the estimated tax penalty was also low.

The short-term rate was running around 3% until just over a year ago. But with the rapid rise in interest rates, the penalty has also risen. The estimated tax penalty is a huge 8 percent from October 1, 2023, through March 31, 2024. This is the highest it has been since 2007. The penalty is not deductible, so your effective penalty rate is much higher than the 8 percent.

With this high penalty rate, avoiding it by paying enough tax during the year is the prudent thing to do. If you opt to ignore this advice, you can look for a penalty waiver from the IRS. However, it’s likely not available to you except in limited circumstances. No such penalty relief is available for corporations.

Estimated Taxes for Individuals

To avoid an underpayment penalty, individual taxpayers must pay 25 percent of their “required annual payment” to the IRS. The payments are due by April 15, June 15, September 15, and January 15.

The required annual payment is the smaller of

  • 90 percent of the total tax due for the current year, or
  • 100 percent of the total tax paid the previous year, or
  • 110 percent of the tax paid the previous year for higher-income taxpayers with adjusted gross incomes of more than $150,000 ($75,000 for married couples filing separately).

Amending the W-4 vs Making Estimated Tax Payments

Individuals who receive most of their income in employee wages usually satisfy their required annual payment through the tax withheld. That assumes, of course, that the withholding certificate (Form W-4) is accurately and timely given to the employer.  However, employees still may need to pay estimated tax if they receive substantial income from which no tax is withheld. Examples are dividends, interest, capital gains and rents. This also applies to taxable distributions from Partnerships, Sub-S corporations and Trusts, and royalties.

Rather than pay estimated taxes, employees can modify their W-4 withholding certificate to increase employee withholding. Individuals who receive taxable retirement account distributions can have all or part of their tax withheld, pay estimated tax, or both.

Estimated Tax Penalty

The estimated tax penalties will be automatically assessed if you do not make the required payments or pay too little. The penalties are not tax-deductible. They are in addition to tax. Because the penalties are not deductible, you pay the penalties with after-tax dollars.

For example, say your combined income and self-employment tax rate is 40 percent. The 8 percent non-deductible penalty rate equals 13.3 percent interest (8 percent ÷ 0.6 percent after-tax rate).

How to Calculate the Penalty

The penalty is figured separately for each payment period. Thus, you cannot reduce the penalty for one period by increasing your estimated tax payments for a later period. This is true even if you are due a refund when you file your tax return. But you can avoid the estimated tax penalty for the fourth quarter if you file your tax return and pay all your tax due by January 31. That is difficult for many taxpayers to do since they may be waiting for 1099 forms, K-1s (partnership, sub-s corporations, and trust distributions), and brokerage statements.

You can calculate the penalty yourself by completing IRS Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, and pay it with your return. Most software packages offer that form as an option.  In the alternative, you can let the IRS calculate the penalty and bill you after the return has been processed.

Estimated Taxes at the State Level

Just a quick comment that most states that have an income tax (such as California) have an estimated tax payment requirement. Failing to make the required payments will typically result in a penalty at the state level as well, although the actual computation and amount of the penalty can differ from state to state.