Understanding IRS Underpayment Penalties: Avoid Costly Mistakes in 2024

By Jason Watson, CPA and The Tax Team

Posted Sunday, July 14, 2024

Dealing with taxes can be tricky, especially when it comes to IRS underpayment penalties. In 2024, these penalties are a bigger deal because the IRS recently bumped up the interest rate to 8% to align with the current landscape. This change means higher costs if you underpay your taxes. Given today’s financial challenges, it’s more important than ever to understand these penalties.

In this article, we’ll break down what underpayment penalties are, why the 8% rate matters, and how to avoid getting hit with extra charges. Stick with us to learn the basics, and you’ll be better prepared to handle your taxes without any nasty surprises.

Underpayment Penalties are just that – penalties for underpaying your taxes. Seems simple enough, right? If you pay as you go the correct amount of taxes due based on your quarterly income, you’re golden – right? Partially. Underpayment penalties could come into play if you earn income unevenly due to the nature of a non-wage work situation, underestimating your 2024 income tax withholding amounts, or significant changes to your income in the course of a year. Other situations could include a change in marital status, tax brackets, or failure to make changes to your filing due to starting or closing a business, retiring, or selling property.

Multiple sources of income could get you into a sticky situation as well. What if you have a job, your spouse works a full-time job, and a part-time job, and you receive a pension? These four sources would likely withhold correctly, but in aggregate they might be short because of the “stacking” effect and tax brackets we just mentioned.

Are you side-hustling on evenings and weekends? Great! We need to account for these activities and their effect on your tax liabilities. Thinking about skipping or skimping on the tax payments this quarter because your side hustle went bust? Let’s talk. It’s not just the fact that you’ll be charged a penalty fee for underpayment (though we think that should be enough to convince you to pay attention!) It’s the fact that there is quarterly interest on these fees, and this year you have 8 reasons to avoid this at all costs with some tax planning and consulting with our tax team.

Here’s a brief history of IRS interest rates to paint the picture for you. Historically, interest rates on underpayments have always been in flux. If you remember – 1982 was a particularly rough year – we had an interest rate that sat at a whopping 20% from February through the end of December. Here’s hoping we never see that again!

We’ve seen spikes over the last 40 years, and our most recent rate of 8% matches Q2 of 2001. Yeah, 8% isn’t as bad as 20%, but it’s still going to put a significant hurt on your bank account, and it’s a huge change from what we had going for us in 2021.

Since Q2 2008, interest rates have hovered around 6-5% dipping down for longer stretches into 3-4% – until 2021. The IRS reassessed rates in 2022 and in just a couple of years we’re already up to 8%. It’s also projected to remain this way through the end of 2024. If you’ve been in business for a while now and avoided underpayment penalties up to this point, but you’re getting lax on those estimated payments, a penalty this year could result in some serious sticker shock if you’re not careful.

Here’s a “real life” example of what an 8% interest rate looks like on paper.

In 2024, Bob Belcher, the owner of Bob’s Burgers, a bustling family owned restaurant, faces a significant tax issue. Bob manages the finances for the restaurant himself, when he’s not actively trying to beat out the competition across the street. Because of this, he overlooked the importance of making accurate and timely quarterly estimated tax payments.

Bob’s Burgers has an estimated annual tax liability of $80,000, requiring them to make four quarterly payments of $20,000 each. However, due to a miscalculation, Bob only paid $10,000 each quarter, underpaying by $40,000 for the year.

When Bob goes to file his annual tax return in 2025, the IRS will determine that Bob has substantially (understatement) underpaid his taxes and asses and underpayment penalty.

Mid-2025, the Bob will receive notice of the IRS underpayment penalty in 2024, calculated at an 8% interest rate. This unexpected expense will strain Bob’s finances, and now Linda will have to go back to working part-time at Fresh Feed to help supplement their income.

Another big reason to care about the 8% interest rate is because it’s based on duration of time taxes remain underpaid.

When you underpay your taxes, the IRS uses a specific formula to calculate the penalty you owe. The penalty is determined by the amount of underpayment and the duration of the underpayment period. For example, if you owed $20,000 in taxes but only paid $15,000, you underpaid by $5,000. If this underpayment lasted for six months before you paid it off, the interest penalty would be calculated as follows:

$5,000 (underpayment) x 8% (annual interest rate) x 0.5 (half a year) = $200.

This $200 penalty is added to your tax bill.

It’s important to note that the penalty can be higher if your state imposes additional underpayment penalties. Some states have their own penalties and interest rates, which can increase the total amount you owe.

For instance, if your state has a 4% interest rate on underpayments, you would owe an additional $100 on the $5,000 underpayment for six months, bringing the total penalty to $300. To avoid these extra costs, it’s increasingly crucial to be aware of both federal and state tax requirements and make sure you make accurate and timely payments. Tax underpayment penalty calculators exist that can help you determine what these rates are and how they could affect your penalty, but we’re hoping you’ll never get to the point where you need to use them!

You’ve heard of the “fail to plan, plan to fail” mantra. Well, the same goes for taxes. Fail to pay, pay for your failure – literally. The best advice we can give to avoid underpayment penalties is to plan, and that’s what we do best! We’ll take the temperature of your current situation to prepare a tax plan, then help you calculate a combination of increased withholdings – including a W-4 update – and/or update your estimated tax payments to better reflect your current financial standing.

We don’t typically rely on or use the “safe harbor” calculation method of avoiding underpayment penalties. These are as follows for information’s sake:

• You pay at least 90% of the tax you owe for the current year, or 100% of the tax you owed for the previous tax year
• You owe less than $1,000 in tax after subtracting withholdings and credits
• If your Adjusted Gross Income (AGI) on your previous year’s return is over $150,000, and you’re married filing jointly (over $75,000 if you’re married filing separately) you must pay the lower of the 90% of the tax shown on the current year’s tax return, or 100% on the return for the previous year
• This doesn’t include any estimated tax payment rules that your state may have that may differ from the IRS, so it may take additional homework to determine the total to calculate

Ideally, you shouldn’t incur underpayment penalties if your payroll withholdings encompass your tax liabilities.

If you receive a penalty notice from the IRS, it’s important to freak out. It’s ok. It’s expected and natural! Then, take prompt action. First, carefully review the notice to understand why you received the penalty and what you (potentially) owe. Dig through your files and cloud, gather all relevant financial records and documentation that might support your case. Muster some courage with your coping mechanism of choice.

Next, contact the IRS as soon as possible to address the issue. Effective communication with the IRS can make a significant difference, and often, it’s beneficial (or better for your mental health) to have a tax professional handle this for you. Unfortunately, Duolingo doesn’t have tax-speak as an option in their app, but we can communicate with the IRS on your behalf, ensuring that your case is presented accurately and professionally in their language.

In some cases, you may be eligible to request an abatement or reduction of the penalty. If you believe the penalty was assessed in error, or if you had a reasonable cause for the underpayment, you can request penalty relief. To apply for an abatement, you’ll need to submit a written request to the IRS, including Form 843, along with any supporting documentation that explains your situation. This could include records of financial hardship, unforeseen events, or honest mistakes.

Again, WCG CPAs & Advisors can assist in preparing and submitting these documents, increasing the likelihood of a favorable outcome and helping you manage your tax obligations more effectively. Menty-b avoided!

Understanding and managing IRS underpayment penalties is crucial, especially with the increased interest rate of 8% in 2024. By staying informed about when these penalties apply, how they’re calculated, and the steps you can take to avoid them, you can better navigate your tax responsibilities. If you do receive a penalty, prompt and effective action is key, and seeking professional help can make the process smoother.

By ensuring accurate withholding and estimated payments, keeping detailed financial records, and consulting with one of our CPAs, you can avoid costly mistakes and ensure compliance with both federal and state tax requirements. We’re here to help you every step of the way to stay on top of IRS underpayment penalties in 2024. From preventing penalties to handling any issues that arise, so you can focus on what you do best – running your business.

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Jason Watson, CPA is a Senior Partner of WCG CPAs & Advisors, a business consultation and tax preparation CPA firm located in Colorado Springs, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online and from mostly average retailers.