How to Avoid Penalties for Underpayment of Taxes

While tax season only comes around once per year, the IRS expects you to pay taxes as you earn income throughout the year. If you pay too little throughout the year, you could face penalties. While employees typically have taxes withheld from their paychecks, self-employed individuals and business owners need to make estimated tax payments. 

However, calculating the amount you need to pay and when you need to pay it can get complicated. To help clear it up, here’s what you need to know about how to avoid underpayment penalties.

What is an underpayment penalty?

The US tax system operates on a pay-as-you-go basis, which means you must pay income tax as you earn or receive income throughout the year. Tax payments are made using the following two methods:

• Withholding: If you’re employed, your employer generally withholds income from your paycheck each pay period and sends it to the IRS on your behalf. Other types of income are also subject to withholding, including commissions, bonuses, pensions, and gambling winnings.
• Estimated tax: If you’re self-employed or own a business, you generally need to set aside income for taxes and make quarterly estimated payments to the IRS. The same rule applies if you earn income that isn’t subject to withholding—like interest, capital gains, royalties, or rental income—and expect to owe $1,000 or more in taxes after subtracting withholding and credits. 

If you don’t pay enough throughout the year and/or end up with too large of a tax balance when you file, the IRS may charge you a penalty for the underpayment of estimated tax.

What triggers the IRS underpayment penalty?

The IRS imposes underpayment penalties based on specific thresholds. The following limits generally apply:

• Corporations: You generally will face a penalty if you owe $500 or more in underpaid estimated tax when you file. 
• Individuals: You generally will face a penalty if you owe $1,000 after subtracting withholding and credits, or if you didn’t pay at least 90% of your current tax, or 100% of your prior year’s tax in estimated payments (110% if your adjusted gross income is over $150,000)—whichever is less. 

If you’re required to make estimated tax payments, each payment must meet the minimum required amount due. For example, you’ll pay $2,500 each quarter if your total estimated tax liability is $10,000 and you use the regular installment method (which spreads payments evenly across four quarterly due dates; more on this later). Underpaying in any specific quarter could result in an underpayment penalty.

A mid-year increase in your tax liability could also trigger a penalty. Even if you refigure your payments to account for the increase, you may be charged the penalty for the periods before you adjusted your payments. In these cases, you might be able to reduce or avoid penalties using the annualized income installment method, which adjusts quarterly estimated tax payments based on income fluctuations throughout the year (more on this later).

Why would I get an underpayment penalty if I receive a refund?

You can still face an underpayment penalty even if you receive a tax refund. This happens if you’re required to make estimated tax payments but don’t pay enough during one or more of your payment periods. The IRS requires you to pay a minimum amount each quarter, calculated using either the regular or annualized income installment method.

The regular installment method

With the regular installment method, you estimate your tax liability for the year and pay one fourth of that amount each quarter. If something changes throughout the year that affects your estimated tax amount, you must recalculate it immediately. You then pay the unpaid balance of your amended estimated tax by the next payment due date and continue on the new plan.

The annualized income installment method

If you don’t receive income evenly throughout the year, you can look into the annualized income installment method. Going this route means you pay less during lower-income periods and more in higher-income periods. Your estimated tax liability is determined as your income accumulates throughout the year instead of dividing your estimated tax liability for the entire year by four as if your income were earned evenly. 

For example, if most of your income comes in the fourth quarter, you may be able to use the annualized income method to shift a larger portion of your payments to that period. However, this method requires you to indicate your choice when you submit Form 2210 with your tax return. On the form, check the box indicating that the reason for filing is that your penalty was reduced or eliminated using the annualized income installment method.. In either case, if the IRS determines you didn’t pay enough during a specific period, you may face a penalty—even if you receive a tax refund when you file.

How to avoid underpayment penalties

Nobody wants to run into surprise costs at tax time. Here are four tips on how to avoid underpayment penalties.

Adjust your withholding

If you’re an employee, make sure you have an updated W-4 on file with your employer and monitor your paychecks to verify your employer is withholding enough tax to avoid penalties. You should also monitor withholdings for other types of income, such as commissions, bonuses, pensions, or gambling winnings. Ensure your withholdings cover the additional tax liability, or have a plan to cover them through estimated payments.

Make estimated tax payments

If you’re self-employed or own a business, stay on top of your estimated tax payments. Whether you decide on the regular or annualized income installment method, keep your total tax liability estimate current and make the minimum required payments on time.

Use the safe harbor rule

The safe harbor rule states that you generally won’t owe an underpayment penalty for the year if you pay at least 90% of your tax for the current year or 100% of the tax shown on your return for the prior year—whichever is lower. 

For those who are high income earners, the rule is a little different. If you have an adjusted gross income of at least $150,000, you must pay 90% of your tax for the current year or 110% of the tax shown on your return for the prior year—whichever is lower. 

If you meet these thresholds through withholding or estimating tax payments, you can generally avoid penalties.

Regularly review tax payments

Regularly review your estimated tax payments to be certain they accurately reflect the tax you expect you’ll owe. If your income, adjustments, deductions, or credits change midyear, recalculate your estimated tax and quarterly payments as soon as possible. And if your income tends to fluctuate throughout the year, consider using the annualized income installment method. 

Tip: Check out our Business Tax Checklist to help you get ready for tax season.

Can a substantial underpayment penalty be waived?

If the tax year ends and you substantially underpaid on either your business or individual taxes, you’ll typically owe underpayment penalties. However, there are some exceptions. 

First, the law lets the IRS waive the penalty if you didn’t make the required payment due to a natural disaster, casualty event, or other unusual circumstance that prevented you from making estimated payments. Additionally, the IRS may waive it if you retired after turning 62 or became disabled during the tax year (or the preceding tax year when the payments were due) and the underpayment was due to reasonable cause. To request a waiver, you may need to file IRS Form 2210 and provide an explanation for the underpayment.

How TurboTax helps individuals and businesses avoid underpayment penalties

Paying taxes throughout the year is a must to avoid IRS penalties but getting it right can be complicated. Employees need to make sure the right amount is withheld from your paycheck, while business owners and those who are self-employed must stay on top of estimated tax payments. If that sounds like a lot to manage, know that you don’t have to do it alone. 

TurboTax simplifies making accurate tax estimates and timely payments. We can help you adjust W-4 withholdings, calculate quarterly estimated taxes, and meet IRS safe harbor rules. Additionally, we’ll flag potential penalties, offer strategies to minimize penalties, and provide reminders for estimated payments. 

TurboTax’s smart insights and payment planning tools can help you stay compliant, avoid costly penalties, and ensure you’re paying the right amount of taxes throughout the year.

Start filing with TurboTax today and take the stress out of tax season!