All You Need to Know About Estimated Tax Penalty Rate

8

Min Read

Tom Smery

When you fail to make the total tax payment for a certain year, the chances are high that you will need to pay a quarterly tax penalty rate. Underpayment of estimated quarterly tax can create a big hole in your budget, which is why you need to watch out for the penalties.

With America's tax system, it might feel overwhelming to figure out exactly how much you have to pay. Calculated incorrectly, you might not be able to file for tax return. This guide will teach you everything you need to know in order to avoid tax liability.

What Is the Penalty Rate for Estimated Tax Payments In 2020?

The penalty rate for estimated taxes in 2020 is 5%. This rate remained unchanged until the 1st of April, 2021, when the penalty became 3%. The IRS changes the penalty amount quarterly throughout the year, which is why you may want to pay attention to this.

For example, many people may meet the due date, but fail to notice that the penalty rate changed in the last year. If they are lucky enough, they overpay the tax and no longer owe anything. However, if they underpay the estimated tax payments, they will have to face an estimated income tax penalty.

What Are the Estimated Tax Payment Deadlines?

Estimated tax payments are due quarterly throughout the year. Payments must be done by the following dates; otherwise, you risk having to pay a penalty:

  • 15th of April
  • 15th of June
  • 15th of September
  • 15th of January

Depending on the circumstances, the IRS may decide to delay certain deadlines. Moreover, the restrictions caused by the COVID-19 pandemic may have affected some of the deadlines.

For example, the individual income tax filing that was due by April 15th, 2021, was postponed to May 15th, 2021. Be sure to carefully watch for any potential announcements from the IRS. You could also pay your entire estimated tax payment at one time when 1099s are due.

Tax payments may also be done monthly instead of quarterly if that is your preference. This option is good if you wish to add a fixed amount to your tax budget.

Who Pays the Estimated Taxes?

People gaining their income through self-employment are not the only ones who have to pay estimated tax payments. Anyone may have to pay these taxes by the end of the tax year. The following payments that aren't subjected to withholding will be subjected to tax liability on income tax:

  • Dividend payments
  • Business earnings
  • Interest
  • Profits from asset sales (i.e., stocks)
  • Taxable alimony

With that in mind, not all businesses need to make estimated tax payments. If your business meets at least one of the following conditions, then you will be exempt from tax payments:

  • You went through a 12-month tax year.
  • You did not owe tax in the year before and did not have to file a tax return.
  • You were a resident or a citizen of the United States for the whole year.

If you owe estimated tax, then you need to pay a close eye to the deadlines for estimated tax payments. If you miss by even one day, you'll be penalized for underpayment of estimated tax.

The penalties and interest will depend on how late you are on making your payment. If you miss a day, it is recommended you make your tax payments as soon as possible. The tax penalty will increase with every passing day in which it remains unpaid.

What Is the Penalty for Not Paying Estimated Taxes?

As one may know, the United States works on a pay-as-you-go system. As a result, taxpayers will make the tax payments based on the money that they have at hand. Very often, they make estimated tax payments or pay their taxes by means of withholding. So, what happens when you pay quarterly taxes late?

Since people are required to calculate their taxes themselves, they may end up not paying enough or simply withholding a tax payment throughout the year. If this happens, you may be liable for penalties. The IRS refers to this as "Penalty for Underpaying Estimated Taxes."

The amount of the tax penalty will depend on how much you owe in estimated taxes. The more you wait, and the more money you owe, the higher the penalty will be.  

How Is The Penalty Calculated?

If you receive self-employment income from your small business, then you need to use Form 1040-ES from the IRS to calculate your estimated tax. By following the steps correctly, you should be able to avoid underpayment of estimated tax.

If the payments are not calculated properly, then the estimated tax penalty will begin to grow with every missed due date. With every day that passes, the interest rate on the penalty may grow - but at the same time, it will also depend on the laws of the IRS.

The Formula To Determine The Penalty

To put it simply, the IRS will use a formula to calculate the estimated tax penalty. This formula is based on how much underpayment amount there was for that quarter in particular.

People with self-employment income generally have a federal short-term rate plus 3%. In this case, however, the penalty rate can change from one quarter to another, in accordance with that federal rate.

For example, up until the second quarter of 2020, the federal short-term rate was a total of 5%. Still, starting with the third quarter, the rate dropped to only 3%. In the same year, there were two different rates for the estimated tax penalty to be paid.

With each installment, the penalty rate will be calculated separately. This may mean that you still owe a penalty, even if you already made shortfall tax payments later in the quarter. In the end, you may make a correct payment for the whole year, but receive a penalty for underpaying in that specific quarter.

The method can change from quarter to quarter, which is why you need to follow the IRS page. On Form 2210, you may find several methods for calculating the penalty amount based on the underpayment amount that you owe.

Calculating the estimated tax penalty can be quite a complicated procedure - and very often, people also make mistakes with how much they owe. This is why, in most cases, the IRS will calculate the underpayment of estimated tax for you instead.

You will be sent a bill so that you won't have to calculate those payments yourself. All you have to do is let a blank space on the penalty line and skip filing Form 2210.

If you succeeded in filing the income tax by April 15th, then you won't be charged any interest rate for the penalty. It will be considered that you paid the amount of tax by the due date the IRS set for you.

What Is the Rate For The Underpayment Of Estimated Tax Penalty In 2021?

The rate for the underpayment penalty in 2021 is between 3% and 5%, depending on the filing. The (a)(2) underpayment penalty rate is 3%, whereas the (c)(1) rate is 5%. The underpayment trends are lower when you compare them to the previous years.

Can the Penalty Be Waived?

Usually, a penalty is incurred whenever someone fails to make a full year's tax payment. In many cases, the penalty will only increase with every passing day. However, there are certain cases in which the penalty for the tax may be waived. It may apply to you if you meet the following requirements:

  • You  made at least 90% worth of tax payments from the tax liability in the current year.
  • You made 100% worth of federal tax payments from the tax liability of the previous year.

In certain circumstances, as long as there is reasonable cause, the IRS may also decide to waive your penalty. Here are the circumstances in which this may happen:

  • You failed to make the payment because of a disaster, casualty, or other unforeseen events.
  • You retired after the age of 62 or became recently disabled.

In most cases, not-knowing neglect that had a reasonable cause is accepted by the IRS. There are a few other exceptions as well, such as for farmers, household employers, and fishermen, all of which you may find in Publication 505 released by the IRS.

How Can You Avoid Penalty?

Obviously, the best way for you to avoid a penalty is to make sure you pay quarterly taxes on time in the first place. Pay your estimated income taxes year-round by their due date, and there shouldn't be any problem.

If you are an employee and have your taxes withheld by the company you are working at, then you may use Form W-4 in order to change the withholding rights. Ideally, this should be done at the beginning of the year; the earlier, the better.

This way, you may do the calculations yourself and avoid any further penalties. Form W-4 can also catch any errors from the previous tax filing process, particularly when you seem to owe more tax money than you're withholding.

If you are self-employed, then your taxes won't be withheld from your self-employed income. You will have to do these taxes yourself. Usually, to avoid any penalties, you might want to file for taxes four times a year, by the IRS deadline.

When making your estimated tax, you might want to factor in the penalty amount as well. Make sure to pay by the deadline, even if you are letting the IRS do the calculations for you. If not, simply use form 1040-ES to calculate the tax payments.

If you reach the end of the tax year and you withheld the total tax amount, then you won't have to worry about being penalized. When the year's tax season comes around, to be sure, you may want to get a hold of form 2210. This way, you will be able to calculate your income tax so that you incur no estimated penalties.

The Bottom Line

Taxes can be quite complex, specifically where the estimated tax penalty rate is involved. Ideally, if you are not completely certain, then you may want to discuss matters with your tax advisor.

Remember that these taxes change by the quarter, so keep a close eye on what the IRS is doing. If the rate changes, you need to take it into account so that you aren't given a tax penalty.

Tom Smery
Tom Smery is a certified CPA for over a decade. In his free time, he writes articles to pass on his expert knowledge on taxes and accounting. Thomas has a wide range of deep knowledge on 1099 taxes, and finance topics. You can find him fishing when he is not preparing taxes for his clients or writing about accounting.

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