What is the IRS underpayment penalty?

The U.S. tax system is pay-as-you-go, which means you’re required to withhold or pay estimated taxes as you earn or receive income. Generally, the IRS expects you to pay at least 90% of the total you owe for the current tax year — or 100% of the tax shown on last year’s return, whichever is less — by  the time you file your federal return, which is typically April 15.

If you end up paying less because you didn’t have enough tax withheld from your paychecks or your quarterly estimated payments were too low, the IRS may penalize you for the shortfall.

Here are things to know about the underpayment penalty, the circumstances that might trigger it and ways you may be able to avoid it.

• What is the underpayment penalty?
• Can I get the penalty waived?
• How can I avoid this penalty in the future?

What is the underpayment penalty?

The underpayment penalty is a fine the IRS may charge taxpayers who don’t pay enough tax through withholdings or estimated payments during the tax year. The IRS imposes different penalties in hopes of encouraging taxpayers to follow IRS rules.

The underpayment penalty may apply if the total of your estimated payments or withholdings (or both) isn’t the lesser of …

• The amount of tax you paid during the tax year is less than 90% of the tax that you owed for the current year
• The amount you paid during the tax year didn’t at least equal 100% of your taxes owed the prior year.

For example, if your federal income tax obligation for the current year was $10,000, but you only paid $8,000 (which is only 80% of your total tax obligation), you could face an underpayment penalty.

In any case, the IRS says you can probably avoid the penalty if the amount you owe is less than $1,000, after subtracting withholdings and refundable credits.

If a penalty applies, you might have to file IRS Form 2210. The IRS typically will calculate the underpayment penalty for you, but in certain circumstances, you may have to calculate your own penalty amount on the form.

Can I get the penalty waived?

The IRS might waive the underpayment penalty in some cases.

Reasonable cause penalty relief

If you can demonstrate that you did your best to pay your tax on time, but circumstances beyond your control prevented you from doing so, the IRS may grant reasonable cause penalty relief. Sound reasons for this type of penalty relief might include that you were the victim of a natural disaster, that a death or serious illness occurred in your immediate family, or that some other unusual event got in the way.

Retirement or disability

You can also ask the IRS to waive the underpayment penalty if you retired (after turning 62) or became disabled during the tax year or in the prior tax year, and the underpayment was due to reasonable cause.

Administrative relief

The IRS might also waive the underpayment penalty when it makes an error, such as giving incorrect advice. For example, if an IRS agent gave you wrong advice verbally, you may qualify for this type of penalty relief.

Tax reform waiver

Because 2018 was the first year many provisions of the Tax Cuts and Jobs Act of 2017 took effect, some taxpayers were confused over how much tax to pay. For the 2018 tax year, the IRS waived the underpayment penalty for any taxpayer who paid at least 80% (rather than the usual 90%) of their total 2018 federal tax obligation by Jan. 15, 2019.

But keep in mind: Even if the IRS waives the underpayment penalty, you’ll still need to pay interest on the balance of your unpaid tax bill and may have to file Form 2210.

How can I avoid this penalty in the future?

No one likes being fined by the IRS, but you can take steps to avoid the underpayment penalty in the future.

Adjust your W-4 withholding

Generally, employers are required to withhold taxes from employees’ paychecks based on the amount you earn and information employees provide on their W-4s. If an employer isn’t taking out enough, you can make up for the tax shortfall by updating your W-4 and asking them to withhold more.

You can use the IRS’ withholding calculator to estimate how much your employer should withhold from your paychecks. Then fill out a new Form W-4, which indicates how much you want withheld, and submit it to your employer.

Make estimated payments

If you’re self-employed or have a side job, you may need to calculate and make estimated tax payments throughout the year. Typically you’re not supposed to wait and pay your tax liability in one lump sum at the end of the year. To help avoid the underpayment penalty, calculate the amount of your estimated payments and be sure you’re making quarterly estimated payments.

Annualize your income

You might choose this option if your income is unpredictable or seasonal and you want to base your tax payments on a reasonable estimate of your income during that period. So if you own a seasonal business and most of your annual earnings are squeezed into three consecutive months, for example, annualizing your income can help you better estimate your tax payments. To use this method, complete Form 2210, Schedule AI and attach it to your return.

Bottom line

Generally, if you don’t pay a sufficient amount of your taxes owed throughout the year, the IRS can impose a fine. For the 2018 tax year, the IRS lowered that threshold to 80% of taxes owed for eligible taxpayers. If you’re still facing the underpayment penalty, you may request to have it waived by showing there’s a reasonable cause or you were unable to calculate your estimated income.

Just make sure you take steps to avoid the penalty in the future by paying the right amount to the IRS throughout the year. To do this, you can ask your employer to withhold more from your paycheck or you can add more to your quarterly estimated tax payments if you’re self-employed.

Rachel Weatherly is a tax product specialist with Credit Karma. She studied accounting and finance at Western Carolina University and has also worked as a tax analyst. You can find her on LinkedIn.