When Do You Have to Pay a Penalty for Underpayment of Taxes?

Owing taxes is one thing, but failing to pay enough throughout the year can lead to penalties. The IRS expects taxpayers to make regular payments if they anticipate owing beyond a certain amount. Falling short can add to an already existing tax bill.

Understanding when and why underpayment penalties occur can help avoid unnecessary costs.

Required Minimum Payments

The IRS requires taxpayers to make payments throughout the year to avoid penalties. This applies to individuals, businesses, and self-employed workers whose income isn’t subject to automatic withholding. If payments don’t meet the minimum threshold, penalties may apply.

For most taxpayers, the required minimum payment is based on total tax liability. If the amount due after credits and deductions exceeds $1,000, payments must be made periodically rather than waiting until the annual filing deadline. These payments can come from wage withholding, estimated tax payments, or a combination of both.

Withholding from wages is the most common way employees meet this requirement. Employers deduct federal income tax from each paycheck based on Form W-4. If too little is withheld, the employee may need to make additional payments. Self-employed individuals and those with significant non-wage income, such as rental earnings or investment gains, must ensure they meet the required minimum payments since they don’t have an employer handling withholding.

Expected Quarterly Filings

The IRS requires certain taxpayers to make estimated tax payments rather than waiting until the annual filing deadline. These payments are typically due in four installments—April 15, June 15, September 15, and January 15 of the following year. If a due date falls on a weekend or holiday, it shifts to the next business day. Missing a deadline or underpaying can result in penalties, even if the total tax owed is paid by April.

Estimated payments are especially relevant for individuals with income sources that do not have automatic withholding, such as freelancers, independent contractors, business owners, and investors. The IRS expects these taxpayers to estimate their annual income, determine tax liability, and divide it into four roughly equal payments. Fluctuating income can make this difficult, and those with irregular earnings may need to adjust payments each quarter.

The penalty for missing or underpaying a quarterly installment is based on the unpaid amount and the number of days it was late. The IRS applies an interest rate, adjusted quarterly based on federal short-term rates. For 2024, this rate is 8% for individual taxpayers. Since the penalty accrues over time, the longer a payment is overdue, the more it will cost.

Safe Harbor Guidelines

To help taxpayers avoid penalties, the IRS provides safe harbor rules that establish minimum payment thresholds. If these conditions are met, no penalty will be assessed, even if taxes are still owed at year-end. These guidelines allow payments based on prior-year tax liability or a percentage of the current year’s expected tax.

Percentage of Current Tax

One way to meet the safe harbor requirement is by paying at least 90% of the total tax liability for the current year through withholding and estimated payments. This method works best for those with stable income who can accurately estimate their tax obligation. For example, if a taxpayer expects to owe $20,000 in federal income tax, they must pay at least $18,000 (90%) in timely installments to avoid penalties.

For individuals with unpredictable earnings, such as freelancers or business owners, this approach carries risk. Underestimating tax liability and paying less than 90% could result in penalties, even if the remaining balance is paid by the deadline. Adjusting estimated payments each quarter based on updated income projections can help mitigate this risk.

Percentage of Previous Tax

An alternative safe harbor rule allows taxpayers to avoid penalties by paying 100% of the prior year’s tax liability, or 110% if their adjusted gross income (AGI) exceeded $150,000 ($75,000 for married individuals filing separately). This method benefits those with variable income by providing a fixed target based on a known figure rather than an estimate.

For instance, if a taxpayer owed $15,000 in federal taxes last year and their AGI was below $150,000, they must pay at least $15,000 in the current year. If their AGI exceeded $150,000, they would need to pay $16,500 (110% of $15,000). This rule ensures that high-income earners contribute a slightly larger portion upfront, reducing the likelihood of a significant tax bill at year-end.

This method is useful for those with income volatility, such as commission-based sales professionals or seasonal workers. However, if income decreases significantly, they may overpay and wait for a refund.

Special Adjustments

Certain taxpayers qualify for adjusted safe harbor rules based on specific circumstances. Farmers and fishermen, for example, only need to pay 66.67% of their current-year tax liability or 100% of the prior year’s tax to avoid penalties. This recognizes the seasonal nature of their income and provides flexibility.

Taxpayers who experience an unusual financial event, such as a large capital gain or a one-time bonus, may need to adjust estimated payments mid-year. The IRS allows taxpayers to use the annualized income installment method, which calculates payments based on actual earnings for each quarter rather than a fixed estimate. This can help those with uneven income distributions avoid penalties by aligning payments with their earnings pattern.

For those who receive a significant portion of income late in the year, adjusting withholding on a paycheck or making a larger estimated payment in the final quarter can help meet safe harbor requirements. Taxpayers can use IRS Form 2210 to determine whether they qualify for an exception based on payment timing.

Calculating the Penalty

The IRS determines the underpayment penalty using a formula that considers the amount underpaid, the duration of the shortfall, and an interest rate tied to the federal short-term rate plus 3%. This interest rate is updated quarterly, meaning the penalty fluctuates throughout the year.

For example, if a taxpayer underpays by $5,000 on an estimated tax installment due April 15 and the penalty rate for that quarter is 8%, the daily interest rate would be approximately 0.0219% (8% ÷ 365). If the shortfall remains unpaid for 90 days, the penalty would be roughly $98 ($5,000 × 0.0219% × 90). If additional underpayments occur in later quarters, each is assessed separately, with interest accrued from the respective due dates.

Accuracy in calculating the penalty is important, as the IRS may adjust it based on when payments were actually made. Taxpayers who make partial payments reduce the outstanding balance, which lowers the penalty amount. The IRS provides Form 2210 to help taxpayers determine their liability, but those with complex financial situations may benefit from consulting a tax professional.

Exceptions and Waivers

While the IRS generally imposes penalties for underpayment, certain circumstances allow taxpayers to request a waiver or qualify for an exception.

One common exception applies to taxpayers who had no tax liability in the prior year. If an individual did not owe federal income tax and was not required to file a return in the previous year, they are exempt from underpayment penalties.

Another waiver is available for those who underpaid due to an unforeseen event, such as a natural disaster, serious illness, or other hardship. The IRS may grant relief if the taxpayer can demonstrate that the underpayment was due to circumstances beyond their control and not willful neglect. Taxpayers seeking this relief must submit a request, often using Form 2210, and provide documentation supporting their claim.

The IRS also offers a waiver for individuals who retired after reaching age 62 or became disabled during the tax year, provided the underpayment resulted from reasonable cause rather than intentional disregard of tax laws.

Steps to Pay the Penalty

If assessed an underpayment penalty, taxpayers have multiple options for resolving the balance.

One option is to pay online through the IRS website using Direct Pay, a debit or credit card, or the Electronic Federal Tax Payment System (EFTPS). Direct Pay allows taxpayers to transfer funds directly from their bank account without fees, while credit card payments may incur processing charges.

For those unable to pay the full amount immediately, the IRS offers installment agreements that allow payments over time. Short-term plans, which must be paid within 180 days, do not require a setup fee, while long-term agreements may involve additional costs. Taxpayers facing financial hardship can also request penalty abatement or negotiate an Offer in Compromise, which allows them to settle their tax debt for less than the full amount owed if they meet eligibility criteria.