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A surging IRS tax penalty is costing Americans billions - here's how to avoid being hit
A surging IRS tax penalty may soon cost some Americans billions of dollars.
Thousands of Americans who pay their income taxes quarterly instead of through paycheck withholding could face a major increase in penalties for underpayments.
There are ways to avoid being hit - but with second-quarter payments due on June 17, affected taxpayers need to take immediate action.
'These charges can hit hard, so getting it right can save people hundreds or even thousands of dollars a year,' Richard Pon, a CPA in San Francisco told The Wall Street Journal.
Certain groups who may fall into this category include investors, retirees, business owners, gig workers, and others who aren’t regular employees.
Thousands of Americans who pay their income taxes quarterly instead of through paycheck withholding could face a major increase in penalties for underpayments
Two-earner couples or employees with stock options could also be subject to penalties if their withholdings are insufficient.
In fiscal-year 2023, the average estimated-tax penalty soared to about $500, up from $150 in 2022, according to the Internal Revenue Service (IRS).
The number of affected tax filers rose to 14 million from 12 million, and the total penalties assessed surged to $7 billion from $1.8 billion in 2022.
Higher interest rates are a key reason for this increase, alongside pandemic-related catch-up assessments.
Employees have been required to pay most of their income tax through paycheck withholding since World War II, or face penalties.
To prevent non-employees from gaming the system, filers with other taxable income—such as from investments or self-employment—must make estimated tax payments quarterly.
If taxpayers don’t pay enough tax throughout the year, they face penalties in the form of an interest charge on their underpayment, set quarterly. In 2021, the IRS’s rate on underpayments was 3 percent.
This rate, based on the short-term Treasury rate plus three points, rose to 6 percent in 2022, pushing up charges on underpayments assessed the following year.
By the fourth quarter of 2023, the rate had climbed to 8 percent, and it remains there, continuing to impact taxpayers with underpayment penalties.
While underpayment penalties can be complex, it’s possible to avoid them by making strategic use of tax rules, the WSJ reported.
One way to avoid unnecessary penalties is pay early.
Taxpayers who owe $1,000 or more must pay 90 percent of their tax bill before the April 15 due date.
For employees, this deadline is year-end, while those with other taxable income must meet the fourth-quarter payment deadline, typically January 15.
But paying the IRS at any time can lower the interest charges, so taxpayers can save by making payments before the April 15 deadline.
One way to avoid unnecessary penalties is pay early.
Taxpayers who owe $1,000 or more must pay 90 percent of their tax bill before the April 15 due date.
Avoiding IRS computer errors is another way to avoid unnecessary penalties.
There are ways to avoid being hit - but with second-quarter payments due on June 17, affected taxpayers need to take immediate action
The IRS’ computers can impose unfair penalties by assuming income is evenly earned throughout the year.
For example, a fourth-quarter Roth IRA conversion might result in penalties because the system treats the income as if it was earned all year.
To fix this, file IRS Form 2210 and Schedule AI, specifying when income was earned and taxes were paid. Check if your tax software supports these forms.
The IRS also often waives penalties for those who recently retired at 62 or older, became disabled, or can show reasonable cause. To request a waiver, individuals can file a simplified Form 2210.
Finally, to avoid penalties, taxpayers must consider the dangers of safe harbors, the WSJ reported.
If ones adjusted gross income is $150,000 or less, paying 100 percent of the prior year's tax by the deadline qualifies.
If your income exceeds $150,000, paying 110 percent of the prior year's tax is necessary.
But these safe harbors apply quarterly, not yearly - meaning that if someone has income in the second quarter but doesn’t pay the safe-harbor amount until the third or fourth quarter, underpayment penalties may still be applicable.