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Understanding Tax Underpayment Penalties: Examples and Prevention


Tax underpayment penalties are fines imposed by the IRS on taxpayers who fail to meet their tax obligations throughout the year. Here's a breakdown of what they are, how they work, and steps to avoid them.

What Is a Tax Underpayment Penalty?

A tax underpayment penalty is a fine levied by the IRS on individuals or businesses who haven't paid enough of their total estimated tax and withholding obligations. To avoid these penalties, taxpayers must generally pay at least 100% of the previous year's tax or 90% of the current year's tax.

How Tax Underpayment Penalties Work

Taxpayers must make payments throughout the year through withholding, estimated tax payments, or both. The penalty is triggered when taxpayers underpay their estimated taxes or make uneven payments that don't align with their income for the period.

Penalties are typically 5% of the underpaid amount, capped at 25%. Additionally, underpaid taxes accrue interest based on rates set by the IRS quarterly.

IRS "Safe Harbor" Rules

"Safe harbor" rules provide relief from penalties if certain conditions are met. Taxpayers can avoid underpayment penalties if they owe less than $1,000 or pay more than 90% of their tax obligation for the year.

Can You Make Estimated Tax Payments All at Once?

Taxpayers, such as sole proprietors, partners, and S corporation shareholders, must make quarterly estimated tax payments if they will owe more than $1,000. While payments cannot be made all at once, they can be made in advance or monthly in advance to suit budget needs.

The Bottom Line

Taxpayers risk underpayment penalties if they fail to pay enough in estimated taxes, withholding, or taxes due. It's essential to explore exemptions or reductions if facing a penalty and ensure taxes are calculated correctly and paid on time. Adjusting tax withholding with employers can also help avoid penalties.

Additionally, it's important to have financial statements that are updated regularly so you or your accountant can forecast tax liability timely and correctly. Redbud Advisors works with clients on a monthly basis to keep their financial statements up to date, while maintaining compliance with all state, federal, and FinCEN taxing authorities.

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