This IRS Change Could Cost You: What You Should Know
Written by
John Csiszar
Edited by
Molly Sullivan
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The penalty for the underpayment of estimated taxes doesn’t affect all Americans, but for those it does, the price has risen. While this is a penalty that can be easily avoided, it still ensnares many self-employed workers who either don’t fully understand it or simply neglect to follow the rules. This includes many workers who have picked up a side gig in recent years and may not know they are susceptible to it.
And now, thanks to increases in interest rates over the past few years, the penalty is larger than it has been in decades. Here are the particulars of the rules for paying estimated taxes, who it most affects and how you can avoid the penalty.
What Is the Rule Regarding Underpayment of Estimated Taxes?
According to IRS regulations, you must make estimated tax payments under the following conditions:
- You’re expecting to owe $1,000 or more in taxes after accounting for withholding and refundable credits.
- You project that your withholdings and refundable credits will be less than the smaller of 100% of last year’s tax or 90% of the tax you expect to pay in the current year.
This means that self-employed workers who expect to owe at least $1,000 in tax nearly always have to make estimated tax payments, as they have no employers to withhold tax from their paychecks. If you fail to do so, in addition to the normal tax you owe, the IRS will assess a penalty for the underpayment of estimated taxes.
How Has the Penalty Changed?
The IRS calculates the penalty for underpayment of estimated taxes every quarter. The rate charged is the federal short-term interest rate plus three percentage points. As recently as March 31, 2022, the penalty rate was just 3%. However, late last year the IRS announced that for the quarter ending March 31, 2024, that rate would be 8%. The upgrade to 8% started in the last quarter of 2023. With the recent increase, if you owe $10,000 in tax but don’t make any estimated payments, you’ll owe an additional $800 when you file your taxes. Just two years ago, that penalty would have only been $300.
Who Is Most Likely To Fall Victim to the Penalty?
Most traditional employees have taxes withheld from every paycheck and don’t need to pay estimated taxes. However, self-employed workers must pay estimated taxes every quarter. While long-time business owners, even those working from home, generally understand this, those new to the gig economy may not be aware of it. These are the workers most likely to fall victim to the penalty, and it can feel severe. Those who are just starting a side gig may not even understand that their income is fully taxable in the first place, and they may be even less likely to know that they’ll have to pay estimated taxes along the way. If you’re generating any type of income, even if you think it’s “not a real job,” it’s your responsibility to learn all you need to know about paying your taxes in full.
How You Can Avoid the Penalty
The way to avoid the underpayment penalty is to stay within the “safe harbor” rules outlined above by the IRS. In other words, pay enough in quarterly taxes so that you cover either 100% of your prior year’s taxes or 90% of what you will ultimately owe in the current year. If your income is fairly stable, you can usually use the 100% guideline as a way to avoid any penalties. However, if your income fluctuates, you’ll have to increase (or decrease) your quarterly contributions in line with what you actually earn. Just make sure you end up paying at least 90% of your ultimate tax liability.
There are a few other options that may allow you to avoid the penalty. First is the annualized income installment method. If you run a business that has variable income, such as a seasonal business like a ski shop, you may be able to reduce or even eliminate your penalty by using this method.
The second, less common method is to qualify for an IRS waiver. This is allowable if an unforeseen catastrophe, such as a natural disaster, prevented you from making payments or would otherwise make it unfair for you to incur a penalty. If you retire after age 62 or become disabled, you may qualify for a waiver if you did not make the underpayment willingly and if you had a reasonable cause for not making sufficient payments.
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