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Don’t Get Caught by Tax Penalties

Ben RuckerThis article is written by Ben Rucker, a former special IRS auditor. He worked with me in writing Advanced Tax Tactics 2.0.

Lately I’ve been getting a lot of questions about tax penalties.  Many taxpayers are surprised to find that they are charged multiple penalties and interest each year.  The government is serious about making sure people follow the rules, even if you don’t know what they are.  Make sure you know what you might be liable for in order to plan for or avoid it.

The most common penalties are:

  1. Failure to Pay Penalty
  2. Penalty for Underpayment of Estimated Tax (Estimated Tax Penalty)

To make matters worse, interest is also added to these penalties, increasing the balance due.

Failure to Pay Penalty

The Failure to Pay Penalty is assessed at a rate of .05 percent per month or part of a month (there is no proration period–you get charged for a whole month even if it was only one day) of your unpaid taxes. The maximum amount for this penalty is 25%. It applies each month or part of a month that the amount remains unpaid and starts accruing the day after taxes are due.

Personal income tax is due on April 15th of each year. Filing an extension lets you file later, but it does not extend the amount of time you have to pay whatever taxes are due.  However, if you requested an extension of time to file your income tax return by the tax due date and paid at least 90 percent of the taxes you owe, you may not face a failure-to-pay penalty.

For example, if my friend Corbin timely files a tax extension granting him until October 15th to file his tax return, and then pays the $5,369 it lists due in federal taxes when he files his return on October 16th , he will incur seven months of penalties and interest:

Failure to Pay Penalty: $5,369 x 3.50% (.05% x 7 months) = $188

Remember, the late payment penalty is charged .05 percent for a part of a month. That one extra day, paying on the 16th instead of the 15th, added an entire month of penalties.

You may have good reason to wait to pay your taxes, but make sure that the reason outweighs the additional amount you will pay in penalties.

Penalty for Underpayment of Estimated Tax

The United States income tax is a pay-as-you-go tax, which means that you must pay tax as you earn or receive your income during the year. You can do this either through withholding an amount from each paycheck or by making estimated tax payments.

If you do not pay any tax during the year, or you pay an insufficient amount of tax through withholding, you might also be required to pay estimated taxes. If you did not pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of this estimated tax. Generally, most taxpayers will avoid this penalty if the following circumstances apply:

  • The total of your withholding and timely estimated tax payments was at least as much as your tax for the previous year.
    • High income earners pay more through a special rule:  If your AGI for the prior year was more than $150,000 ($75,000 if your status is married filing a separate return), you will be required to pay at least 110% of the previous year’s tax instead of 100%.
  • The tax balance due on your return is no more than 10% of your total previous year’s tax, and you paid all required estimated tax payments on time.
  • Your total tax minus your withholding is less than $1,000.
  • You did not have a tax liability in the previous tax year.
  • You did not have any withholding taxes and your current year tax (less any household employment taxes) is less than $1,000.

The penalty calculation for underpaying your estimated tax is not at all straightforward. In some circumstances you may not incur any penalty. The IRS does not take action when you miss an installment payment.  They don’t take note, nor do they care. Because it’s an “estimated tax,” it’s subject to change. Many businesses nose-dive and so you could have a loss for the year.  There is no need to make an estimated tax payment if you suspect nothing will be due.

Almost every tax software tax program can make the calculation.  You must complete form 2210 and file it with your tax return in order to determine the amount (if any) of the penalty. The rate can be as small as .00008 or as high as .02383.  You should also make sure you check with your state, since there are state penalties for not paying as well.  It can all add up pretty quickly.

When To Pay Estimated Taxes

The IRS won’t bother to figure out if you didn’t pay enough estimated tax until you file your income tax return, but it will look back at that point to make sure you paid what you should have when you should have.

For estimated tax purposes, the year is divided into four payment periods. Each period has a specific payment due date. If you do not pay enough tax by the due date of each of the payment periods, you may be charged a penalty even if you are due a refund when you file your income tax return.

If a payment is mailed, the date of the U.S. postmark is considered the date of payment. The payment periods and due dates for estimated tax payments are as follows:

For the period: Due date:
Jan. 1 – March 31 April 15
April 1 – May 31 June 15
June 1 – Aug. 31 Sept. 15
Sept. 1 – Dec. 31 Jan. 15, next year

How To Figure Estimated Tax

To figure your estimated tax, you must figure your expected adjusted gross income, taxable income, taxes, deductions, and credits for the year.

When figuring your estimated tax for the current year, it may be helpful to use your income, deductions, and credits for the prior year as a starting point. Use your prior year’s federal tax return as a guide. You can use the worksheet Form 1040-ES (PDF) to figure your estimated tax. You will need to estimate the amount of income you expect to earn for the year. If you estimated your earnings too high, simply complete another Form 1040-ES worksheet to refigure your estimated tax for the next quarter. If you estimated your earnings too low, again complete another Form 1040-ES worksheet to recalculate your estimated tax for the next quarter. You want to estimate your income as accurately as you can to avoid penalties.

You must make adjustments both for changes in your own situation and for recent changes in the tax law.  Keeping on top of this throughout the year can save you thousands in lost fees later.

3 Comments
  1. I am looking for a professional tax prepare who is aggressive and understands real estate. I am not happy with my tax preparer i feel that they are working for the government not for me!

    I am an independent contractor and real estate investor. My husband has a another job and we both are investors. the tax preparer would not let me write off any of his travel expenses to our recent real estate investor conference stating my husband is not spending HOURS in the business of rental.

  2. Thank you Ben so much for this valuable information
    Are you available to discuss an estate situation in Pennsylvania where my parents passed away and I have to file an inheritance return and deal with future annuity payments to a trust
    What are your fees for consultation ?
    Thank you

  3. Peggy,
    Ben says, “Clearly her accountant doesn’t understand the PAL ‘passive activity loss rules’ in section 469.” He would be happy to talk with you; his contact information is available on his website at http://irstaxrelief.com/.

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