A Surging IRS Penalty Is Costing Americans Billions. Here's How to Avoid It.

Here’s a wake-up call for millions of Americans who pay some or all their income taxes quarterly rather than through paycheck withholding: Penalties on underpayments of these taxes have surged recently. Second-quarter amounts are due June 17, so affected taxpayers need to act right away.

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The average estimated-tax penalty in fiscal-year 2023 climbed to about $500 from about $150 in 2022, according to Internal Revenue Service data. Meanwhile the number of affected tax filers rose to 14 million from 12 million. Overall, the agency assessed $7 billion in estimated-tax penalties in 2023, nearly four times the $1.8 billion it assessed in 2022. A key reason for the increase is higher interest rates, according to an IRS spokesman, although the total includes some pandemic delay catch-ups.

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Taxpayers who owe $1,000 or more normally must pay 90% of their tax bill long before the April 15 due date. For employees the deadline is yearend, and for those with other taxable income, the deadline is when fourth-quarter payments are due–typically Jan. 15. If taxpayers don’t pay the 90% and aren’t protected by so-called safe harbors described below, they can owe a penalty that’s an interest charge on the underpayment. The rate is set and published quarterly by the IRS; currently it’s 8%. Making a payment to the IRS at any point can reduce this interest–so filers facing these charges can save by making payments before their April 15 due date.

Many taxpayers are aware of safe harbors that protect against estimated-tax penalties. They’re available to filers who pay the IRS 100% of their prior-year tax by the yearend or Jan. 15 deadline if their adjusted gross income is $150,000 or less. Taxpayers earning more must pay 110% of the prior-year tax to qualify.

Beware: These safe harbors apply per quarter, not per year. So if someone has income in the second quarter but doesn’t pay the safe-harbor amount until the third or fourth quarter, underpayment penalties could apply.

The IRS’s computers can impose undeserved penalties on some estimated-tax filers, because they automatically treat income as though it’s earned equally throughout the year. So if a filer does a fourth-quarter Roth IRA conversion and pays tax on it at that time, the system will assume the income was earned all through the year but the tax was only paid in the fourth quarter. The way to tackle this dilemma is to file IRS Form 2210 and Schedule AI, which tells the IRS in what quarters income was earned and taxes were paid. DIY filers with uneven income should check whether their software can handle both forms, as some programs can’t.

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