Net income provides a more accurate account of the financial status. Here’s why.
What is an underpayment penalty?
An underpayment penalty is a penalty charged to a taxpayer who does not pay enough toward his tax obligation throughout the year. Taxpayers subject to the underpayment penalty use Form 1040 or 1040A to determine the amount.
The United States has a pay-as-you-go tax system. This means that taxpayers are expected to pay income tax as they earn their income throughout the tax year.
Taxpayers make payments via two common methods: payroll withholding and estimated quarterly tax payments. If your withholding is not sufficient to cover your ultimate tax obligation for the year, you may have to pay an underpayment penalty. You can use the following guidelines to see if your withholding is sufficient:
- Withholding equals approximately 90 percent of your income tax obligation for the year.
- Withholding equals 100 percent of your previous year’s income tax obligation.
In some cases, taxpayers are not subject to an underpayment penalty. The IRS waives the penalty for the following situations:
- Taxpayer was unable to make sufficient quarterly payments due to a natural disaster, casualty, or unforeseen circumstance.
- Taxpayer retired during the tax year.
- Taxpayer became disabled during the tax year.
There are also specific rules concerning underpayment penalties for those with variable income, such as farmers and anglers.
Underpayment penalty example
If your tax situation changes or you neglect to make regular tax payments, the underpayment penalty may apply to you. For example, assume that your income tax obligation for the prior tax year was $4,000. This year you withheld $4,500, but your income tax obligation is $6,000. Since you withheld more than the prior tax year’s income tax obligation, you do not have to pay the underpayment penalty. Now, assume that you made estimated tax payments of only $2,000. This is approximately 31 percent of your tax obligation ($2,000 divided by $6,500), and it is less than your prior year’s income tax. You will likely have to pay an underpayment penalty unless you meet other criteria specified by the IRS.
Ready to get a handle on your tax situation? Check out these tax calculators.