The IRS imposes an underpayment penalty if you don’t pay enough tax throughout the year, either through withholding or by making timely estimated tax payments. This penalty has recently surged, reaching a significant 8% interest rate. This increase particularly impacts gig workers, consultants, freelancers, and other self-employed individuals who are responsible for their own tax payments.
Who is at Risk for an Underpayment Penalty?
You may face a penalty if you pay less than 90% of the tax you owe for the current year. This often affects:
- Gig Economy Workers & Consultants: Individuals who are paid on a pay-as-you-go basis and do not have taxes withheld.
- Employees with Additional Income: Those who earn side income and fail to adjust their withholdings or make estimated payments.
- Investors: Individuals who receive unexpected or higher-than-usual dividend or capital gain payments.
How to Avoid the Tax Underpayment Penalty
The key to avoiding this costly penalty is to meet one of the IRS “safe harbor” rules. You will not be penalized if:
- You Owe Less Than $1,000: Your total tax due after subtracting withholdings and credits is less than $1,000.
- You Paid 90% of Your Current Year’s Tax Bill: You paid at least 90% of the total tax you owe for the current tax year through withholding or estimated payments.
- You Paid 100% of Last Year’s Tax Bill: You paid 100% of the total tax shown on your prior year’s tax return.
- Higher Income Exception: If your adjusted gross income (AGI) was over $150,000 (or $75,000 if married filing separately), you must pay 110% of last year’s tax liability to meet this safe harbor rule.
The Bottom Line for Taxpayers
With the IRS penalty rate at a multi-year high, proactive tax planning is essential. For gig workers and those with variable income, calculating and paying estimated taxes quarterly is the most effective way to avoid a surprise tax bill and a hefty penalty. Stay informed and ensure you are making timely payments to Uncle Sam.
