Underpayment Penalty: What It Is, How to Avoid It

What is an underpayment penalty?

An underpayment penalty is a charge the IRS imposes on taxpayers who did not pay all of their estimated income taxes for the year or paid their taxes late. You’ll face an underpayment penalty if you:

• Didn’t pay at least 90% of the tax on your current-year return or 100% of the tax shown on the prior year’s return.

• Paid your estimated taxes late.

If you work for an employer, you may be hit with this penalty because the tax that was withheld from your paycheck during the year didn’t cover your full tax liability. If you’re an independent contractor, you may be penalized for missing or underpaying one of the quarterly estimated tax payments.

This penalty only applies to those who owe $1,000 or more in unpaid taxes. If you’re subject to this charge, you’ll receive an IRS notice in the mail.

IRS underpayment penalty rate

The IRS publishes new underpayment penalty rates each quarter. This quarter (October through December), the underpayment penalty interest rate is 8%.

How to avoid the underpayment penalty

If you paid at least 90% of the tax on your current-year return or 100% of the tax shown on the prior year’s return, you can avoid the underpayment penalty for estimated taxes.

Another way to avoid an underpayment penalty in the future is to adjust your withholdings on your W-4, if you have an employer. Reducing your number of dependents or adding an extra withholding amount on line 4(c) can help ensure you’re having enough tax withheld from your paycheck to cover your tax bill. You can use the IRS withholding estimator to check whether you’re on track.

If you’re an independent contractor who pays quarterly estimated taxes, stay on top of each quarter’s due date, and make sure you’re accurately calculating and paying what you owe to avoid the underpayment penalty.

Exceptions to the underpayment penalty

The IRS may waive an underpayment penalty under certain circumstances, such as if you:

• Had the majority of your income tax withheld at the beginning of the year.

• Have varying income throughout the year.

• Became disabled and had reasonable cause to underpay.

• Retired in the past two years after reaching age 62 and had reasonable cause to underpay. 

• Went through an unforeseen circumstance, such as a local disaster or a casualty. 

• Are a farmer or fisherman who paid all tax due by March 1.

If you can’t pay your bill on time …

You should still consider filing your tax return, even if you can’t afford to pay your bill. The IRS imposes a failure-to-file penalty on taxpayers who file late or don’t file, which is typically 5% of any unpaid taxes, up to a maximum of 25%.

It’s also a good idea to pay as much as you can when you file. On top of the underpayment interest charge, you could face a late-payment penalty (also sometimes called the failure-to-pay penalty). This is an additional charge of 0.5% of any unpaid taxes for each month or partial month the tax goes unpaid, capped at 25% of your tax bill.

If this all sounds a bit overwhelming, there is some good news: The IRS offers payment plans that allow taxpayers to pay their bill over time. Getting on a payment plan can help reduce penalties (for instance, the late-payment penalty is cut in half), and it can prevent a tax levy or lien.