3 painful tax penalties and how to avoid them

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Owing taxes is bad enough, but penalties and interest can make the financial pain substantially worse.

You can be hit with tax penalties for:

  • Filing what the IRS considers a frivolous tax return.
  • A variety of retirement account actions or inactions.
  • Filing an inaccurate return due to negligence or disregard of rules.

But penalties are most often triggered for these three basic taxpayer offenses:

  1.    Not paying what is owed.
  2.    Not filing a tax return at all.
  3.    Not paying enough tax throughout the year.

Failure-to-file, failure-to-pay penalties

Did you miss the tax deadline? The penalties are more severe if you don’t file on time than if you don’t pay on time.

  • Not filing your return will cost you an additional 5 percent of your unpaid tax bill each month.
  • Not paying what you owe will add an extra 0.5 percent each month to your overall IRS debt.
  • If you did not file on time and did not pay any tax you owed, you are subject to both penalties. However, the IRS actually gives you a bit of a break. The maximum penalty that you’ll pay for both in any given month is 5 percent, rather than 5.5 percent.
  • If you don’t file or pay for five months, the failure-to-file penalty will max out at 25 percent of your unpaid taxes. But the 0.5 percent failure-to-pay penalty will continue to accrue, up to another 25 percent of what you owe, until the tax is paid.
  • Interest also is charged on the overdue amount.

If you didn’t file a tax return or file for an extension by the mid-April deadline, the 5 percent penalty for not filing started accruing the very first day past the deadline. The full monthly charge for failing to file applies for any part of a month you’re late in sending in your tax return. So if you file on May 1, you still are assessed the monthly 5 percent penalty for that month.

If you are due a refund, you don’t have to file, but that’s the only way to get your money.

Once you have it, you could put your tax refund in a high-yield savings account. Compare rates at Bankrate.

What if you don’t owe any or very much tax? Tax law still requires you to file. And if you owe only a small amount but wait more than 60 days to file a tax return, the minimum failure-to-file penalty is the smaller of $210 or 100 percent of the unpaid tax.

Underpayment penalty

U.S. taxes are collected on a pay-as-you-earn system.

Most of us comply, thanks to income tax withholding from our paychecks. But if you’re an independent contractor, either full time or as a side job, you are responsible for covering the tax due on those earnings through estimated tax payments.

If you don’t meet that requirement, you’ll be hit with a tax underpayment penalty.

The same timely tax paying applies to other income, such as prize winnings, investment earnings and even stock options.

Sometimes, people who receive these various types of untaxed income pay what they owe the IRS in one lump sum when they file their taxes — but that tax payment plan is incorrect. The IRS wants its portion of your earnings when you get the money. If you fail to pay at the appropriate time, you could owe an underpayment penalty, even if you eventually paid the full tax due. 

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Avoiding the underpayment penalty

There are a few ways to get around the tax underpayment penalty.

First, you can meet one of two estimated tax-filing safe harbors. Pay estimated taxes that are the lesser of 100 percent of your prior year’s tax liability or 90 percent of your current year’s tax liability.

If you have a salaried job, you can make up for estimated tax shortfalls by increasing your withholding. For married couples who file jointly, a spouse’s withholding will cover any shortage of estimated taxes due on the other spouse’s untaxed income.

Use the IRS’ recently updated online withholding calculator to see if you should withhold more taxes from your paycheck.

Alternatively,  you can annualize your income. Here you file Form 2210, breaking down income and deductions by estimated tax period, showing that you paid as you should have for each. So if your snow-plowing business only took off near the end of the year for instance, annualizing would show that you correctly paid taxes in the first three quarters of the year, justifying a higher payment in the last quarter.

Other penalty options plus interest

If you face a tax penalty for the first time, the IRS might be lenient.

Remember, though, even if the IRS grants some penalty relief, you’ll still face interest charges on unpaid taxes.

So always file your 1040 on time, pay any taxes due with that form, and keep track of and pay enough estimated taxes on your other earnings. That will ensure that you won’t have to pay out any more money than necessary.