Blog
The Estimated Tax Penalty: How To Avoid IRS Penalties And Interest
Introduction
When it comes to taxes, the IRS commonly assesses various penalties and interest, especially for late filing, late tax payments, and underpayments of estimated tax. It’s important to ensure you’re paying the correct amount of tax on time and in line with IRS legislation. In this article, we’ll explore the landscape of IRS penalties and interest, emphasizing the crucial role of timely tax planning for individuals and businesses.
Overview – IRS Penalties and Interest
Understanding the nuances of IRS penalties and interest is paramount for every business owner, as these charges can rapidly compound if overlooked.
Late Filing of Tax Returns
Late filing occurs when you submit your tax return after the initial IRS deadline or after your extension deadline has passed (if you received an extension). Penalties and interest are commonly charged in these circumstances.
Late Payment of Taxes
Late payment penalties arise when tax payments (including estimated taxes) are received after the initial deadline. It’s essential to distinguish this from filing extensions, as an extension to file does not grant an extension to pay. This distinction is often misunderstood and can result in added complications for businesses. Interest is also assessed in addition to late payment penalties.
Estimated Tax Penalty
Estimated taxes are quarterly tax payments made to the IRS. They are usually required if you earn investment income, business income, or other non-salaried income throughout the year. Estimated tax payments cover income tax, self-employment tax, and alternate minimum tax. If you underpay your estimated taxes throughout the tax year, you may be charged an estimated tax penalty which is based on IRS interest rates that are published quarterly. In 2024 the estimated tax interest rate jumped to 8%, up from 3% back in 2021. Because of this, it’s important to plan carefully and ensure you’re not underpaying your estimated taxes throughout the year.
How to Pay Estimated Taxes
You can pay your estimated taxes (and avoid an estimated tax penalty), via two methods: employer withholding or voluntary payments (also called quarterly estimated taxes).
Employer Withholding from W-2 Wages
Employer withholding is a straightforward method of ensuring taxes are deducted from your wages each pay cycle. This method provides a reliable and consistent approach to meeting your tax obligations.
Voluntary Payments: “Quarterly Estimated Taxes”
You can also make voluntary payments, usually called “quarterly estimated taxes,” which is where you pay a lump sum tax payment to the IRS each quarter. By making quarterly payments, you can distribute your tax responsibilities evenly throughout the year, minimizing the risk of facing an estimated tax penalty.
Electronic Filing and Payment Options – You can pay your estimated taxes electronically as part of your quarterly or annual filings.
Mail Check Voucher – You can pay your estimated taxes via a mail check voucher. These are generally due on 4/15, 6/15, 9/15, 1/15. You can also make payments at other times that suit you, i.e. paying a large first quarter payment which covers the whole year.
IRS or State Agency Websites – You can also pay your estimated taxes online via the IRS website, or via state agency websites.
Electronic options streamline the estimated tax process and provide businesses with a secure and efficient way to fulfill their tax obligations. It also minimizes the risk of errors, and helps to ensure you don’t get charged with an estimated tax penalty for late filing or payment.
Estimated Tax Penalty – Underpayment
If your tax payments during the year were insufficient (whether through employer withholding or estimated tax payments), you may be subject to an estimated tax penalty. This penalty can be avoided if your tax liability is less than $1,000 after accounting for withholdings and credits paid during the year. Alternatively, the penalty won’t apply if you have paid either 90% of the current year’s tax liability or 100% of the prior year’s tax shown on your return (or 110% if your AGI was over $150,000 or $75,000 if married filing separately).
It’s important to calculate your non-salaried income so that you can correctly estimate your income tax liability. The estimated tax requirements differ depending on the industry, especially farmers, fishermen, and high-income taxpayers.
The 2024 interest rate increase to 8% highlights the importance of meticulous tax planning. By reevaluating your business strategies, tax planning processes, and cash flow, you can ensure you’re prepared for the implications of this interest rate increase (and avoid it altogether).
Remove Or Reduce A Penalty
In limited circumstances, for example, the death of a family member, serious illness or injury, or other extreme circumstances outside your control, you can apply to the IRS to have the estimated tax penalty waived. However, keep in mind that interest is not waived on late filings or payments.
How To Avoid An Estimated Tax Penalty
When calculating interest and penalties, the IRS uses your periodic income (i.e. quarterly income), and estimated tax payment amounts and dates. There are a few strategies you can employ to avoid an IRS-estimated tax penalty and associated interest charges.
A. Utilizing Overpayments
Suppose your tax return resulted in an overpayment of tax in the previous year. In that case, you can apply all or part of it to the following year as an estimated tax payment in the first quarter (and the following quarters if the overpayment was large enough). The overpayment can replace the payment with an extension request.
B. Choosing Withholdings over Quarterly Payments
While estimated tax payments can vary and be larger lump sums, the IRS considers payroll withholdings as paid evenly throughout the year (even if they are paid late in the year).
For example, if you’re a business owner who projects a $30,000 tax liability for the year, you could pay a Q4 estimated tax payment on January 15 and be subject to an estimated tax penalty. Alternatively, by implementing timely tax planning, you could increase your Q4 payroll withholdings by $30,000 and not face an estimated tax penalty because the IRS assumes the payroll withholding was paid evenly over the full year. Lastly, you could pay yourself a bonus and withhold $30,000 in taxes, but you will pay extra payroll taxes, which is not ideal.
Benefits of Timely Tax Planning
Partnering with a professional CPA accounting firm adds a layer of expertise to your tax planning strategy. There are many benefits to tax planning, including:
- Minimizing Your Tax Liability – A CPA firm can help you identify and avoid unnecessary taxes while highlighting additional deductions and expenses related to your industry.
- Increased Cash Flow and Savings – Effective tax planning leads to higher savings and cash flow, resulting in greater profitability for individuals and businesses.
- Avoidance of IRS Penalties and Interest – Timely tax planning ensures compliance with tax laws and helps you adhere to IRS filing and payment deadlines. This minimizes the chance of an estimated tax penalty and interest charges.
Conclusion
Being aware of IRS legislation changes and updates is crucial to ensuring you don’t get charged unnecessary penalties and interest for late or missed payments and tax filings. By working with an expert CPA firm, you can reduce your tax liability while improving profitability and ensuring peace of mind. To find out more about estimated tax penalties and how to avoid them, book a call with our team here at Drilldown Solution.
Check Out Our Other Popular Blogs
5 Keys to Putting Kids and Family Members on the Payroll
How Much Can a Small Business Make Before Paying Taxes
Note: The material and contents provided in this article are informative in nature only. It is not intended to be advice and you should not act specifically on the basis of this information alone. If expert assistance is required, professional advice should be obtained.
