How the Federal Underpayment Rate Works
Understand how the IRS underpayment rate is a calculated interest charge on unpaid taxes, determined by a specific formula, not a simple flat penalty.
The federal underpayment rate is an interest charge applied by the Internal Revenue Service (IRS) to unpaid tax liabilities. When a taxpayer does not pay the full amount of tax owed by the required deadline, this rate serves as compensation for the time value of that money, functioning similarly to interest on a loan. The charge is not intended to be punitive but is a mechanism to maintain the tax collection system. It reflects the cost of the delayed payment to the U.S. Treasury.
How the Federal Underpayment Rate is Set
The federal underpayment rate is not an arbitrary figure but is determined by a formula in the Internal Revenue Code. For most taxpayers, the rate is calculated by taking the federal short-term rate and adding three percentage points. This structure links the underpayment rate to broader economic conditions, as the federal short-term rate is based on market yields of certain U.S. government debt obligations.
The IRS determines and publishes the federal short-term rate, and the overall underpayment rate is established quarterly. This means the rate can change four times a year, and the rate that applies to an underpayment depends on the quarter in which the tax was unpaid. For example, the rate for the first quarter applies to underpayments during January, February, and March.
When the Underpayment Penalty Applies
The U.S. has a “pay-as-you-go” tax system, meaning taxes must be paid as income is earned throughout the year. The underpayment penalty applies when a taxpayer has not paid enough tax via withholding or estimated tax payments. If the total tax paid during the year is insufficient, a penalty may be assessed.
To avoid this penalty, taxpayers must pay at least 90% of the tax owed for the current year or 100% of the tax shown on their prior-year return, whichever is smaller. For taxpayers with an adjusted gross income (AGI) over $150,000 in the prior year ($75,000 for married filing separately), the threshold increases to 110% of the prior year’s tax. Failing to meet one of these safe harbors can trigger the penalty.
The penalty also applies if a taxpayer does not pay the full liability on their return by the original due date. An extension to file is not an extension to pay, and any tax unpaid by the April deadline is subject to interest. The penalty is not applied if the total tax owed after withholding and credits is less than $1,000.
Calculating the Underpayment Penalty
The underpayment penalty is not a single, flat fee. It is an interest charge that accrues on the unpaid amount for the duration of the delinquency. The calculation is based on the underpayment rate in effect for each period the tax remains unpaid, and the interest is compounded daily.
Taxpayers can use specific IRS forms to determine the exact penalty amount. For individuals, estates, and trusts, Form 2210, “Underpayment of Estimated Tax by Individuals, Estates, and Trusts,” is the primary document. Corporations use Form 2220, “Underpayment of Estimated Tax by Corporations.” These forms guide the user through a calculation, breaking the year into four quarterly payment periods.
While taxpayers can complete these forms themselves, it is not required. A taxpayer can file their return without calculating the penalty and wait for the IRS to calculate it and send a bill. If the bill is paid by the date specified, no further interest will be charged on the penalty itself. For taxpayers with fluctuating income, Form 2210 includes a schedule for the annualized income installment method, which may reduce or eliminate the penalty.
Different Rates for Specific Situations
The Internal Revenue Code specifies different rates for certain situations. A higher rate applies to large corporate underpayments from C corporations when the amount exceeds $100,000 for a taxable period. For these underpayments, the interest rate is the federal short-term rate plus five percentage points. This increased rate, sometimes called “hot interest,” begins to accrue 30 days after the IRS sends the corporation a notice of the deficiency.
The IRS also pays interest on overpayments, which occur when a taxpayer pays more tax than they actually owe. For non-corporate taxpayers, this overpayment rate is the same as their underpayment rate. For corporations, the overpayment rate is lower, set at the federal short-term rate plus two percentage points. For any portion of a corporate overpayment exceeding $10,000, the rate is reduced further to the federal short-term rate plus one-half of a percentage point.