What to Know About IRS Underpayment Penalties and Payment Plans
If you're not mindful, the IRS could charge you a penalty for underpaying taxes.
Cynthia Bowman
Contributing Writer at Tally
December 16, 2021
If you earn income, you’ll owe taxes to the U.S. government and possibly your state and local governments. The Internal Revenue Service (IRS) sets tax laws and regulations regarding the federal tax code.
One of those regulations is known as "pay as you go." This means that taxpayers make estimated tax payments throughout the year to match their income.
If you don’t pay enough tax, you may be charged with an underpayment penalty, also referred to as an estimated tax penalty.
We'll outline everything you need to know about IRS underpayment penalties. Specifically, we'll go over what they are and what you can do to prevent them. We'll also cover IRS payment plan interest rates, which could come into play if you cannot repay your federal income tax balance.
What is a pay-as-you-go tax system?
The United States has a pay-as-you-go tax system. That means you must pay taxes throughout the year. Your gross income is the basis for the amount of tax you owe. You can’t wait until the end of the year and pay them all at once.
There are two ways in which you can pay the IRS throughout the year.
Withholdings
If you work for an employer, you will fill out a Form W-2. Your employer will withhold taxes on your behalf, and you can also elect to make additional withholdings.
Making quarterly payments
If you expect to owe $1,000 or more in taxes when you file your income tax return, you are required to make these payments. The due dates are as follows:
The payment period of January 1 to March 31 is due April 15.
The payment period of April 1 to May 31 is due June 15.
The payment period of June 1 to August 31 is due September 15.
The payment period of September 1 to December 31 is due January 15 of the following year.
What are the situations in which you don't have to pay estimated taxes?
Most Americans have to pay estimated taxes on their income. The only situation where you don’t have to pay is if all three of the following are true:
You had no tax liability last year (you didn’t owe any taxes)
Your prior tax year covered 12 months
You were a U.S. citizen for the entire previous year
Unless all three of these are true, you’ll owe taxes. If you don’t pay enough throughout the year, you may be charged an underpayment penalty.
What are IRS underpayment penalties?
An IRS underpayment penalty is charged if you don’t pay enough income taxes. If you work for an employer, the company should withhold enough that you aren’t penalized.
But if you earn self-employment income, you’re responsible for fulfilling your tax obligations and paying throughout the year. In addition to your income taxes, you must also pay a self-employment tax.
If you’re self-employed and work a job where you earn W-2 income, you can request that your employer adjust your tax withholdings to ensure you’re paying enough to cover both sources of income.
No matter what type of income you earn, you’ll likely need to pay penalties if you underpay by more than 10% of what's owed. Should you underpay by less than 10%, you’re still obligated to pay the IRS, but you won’t be assessed penalties or fees.
The same is true if you pay at least 100% of your taxes from the prior year. This means if you owed $10,000 in taxes on your 2020 income tax return, and you paid that in withholdings and quarterly estimates in 2021, you wouldn’t be penalized, even if you end up owing $15,000 in total taxes for the year.
Furthermore, the IRS may grant waivers if the underpayment was made due to unusual circumstances like a natural disaster. They may also waive fees if you retire (and are at least 62) or become disabled during the tax year you owed payments or the year prior. The underpayment also has to be due to reasonable cause and not neglect.
How much is the IRS underpayment penalty?
The amount you are penalized by the IRS will depend on a few things, including:
The total amount of the underpayment
When the underpayment was due
The interest rate applied to the payment
In short, the penalty amount will vary based on how much you owe and how long you've owed it.
When it comes to the IRS interest rates, they change quarterly and are based on the federal short-term rate plus 3%. The interest compounds daily.
If you’re late making a tax payment or fail to file your taxes on time, there may be additional penalties.
How can you figure out how much to pay in taxes?
The IRS website recommends that individuals use Form 1040-ES to determine how much tax they will owe for the current year. The IRS also offers a Tax Withholding Estimator so you can determine how much you need to pay throughout the year to avoid being penalized.
If you prepare ahead of time, you can avoid IRS underpayment penalties. For instance, if you earn income from a side hustle, you shouldn’t put all of your money in a checking account. Instead, determine what percentage you’ll need to pay at the end of the quarter. Consider putting that in a savings account to earn a bit of interest and then paying the IRS when your estimated earnings are due.
What happens if you owe money to the IRS?
If you owe money to the IRS, you’re required to pay the tax balance due plus any penalty fees and interest.
One option is to pay the amount owed in full. But if your balance grows to the point where you cannot pay it, you may want to consider setting up an IRS installment plan that breaks up your unpaid tax debt into smaller monthly payments.
How can you set up an IRS payment plan?
If you’ve received an IRS notice that you owe money and can’t afford to make a lump-sum payment, don’t get overwhelmed. You can opt to set up an IRS installment agreement.
If you can repay your income tax debt within 180 days, you’re eligible for a short-term payment plan. Long-term payment plans are for larger tax debts that will take longer than 180 days to repay.
Both types of installment agreements are easy to set up. You can:
Call the IRS at (800) 829-1040
Complete the Form 9465 Installment Agreement Request. You can submit the form at an IRS walk-in office or mail it in.
To apply for an IRS installment agreement, you’ll need to round up the following information:
A valid email address
Your name as it appears on your most recent tax return
Your Social Security number or Individual Tax ID Number (ITIN)
Your address as shown on your most recent tax return
Date of birth
Filing status (single, married, etc.)
The amount of back taxes due
Once you follow the process, the IRS will need one of the following to verify your identity:
A cell phone number registered in your name
Your bank account number
You’ll need to choose from the following monthly payment options to pay your outstanding balance and accumulated interest:
Check
Credit or debit card, although additional fees will apply on credit card payments
If your tax debt balance is over $25,000, the only payment option available is the Direct Pay method that debits automatically from your designated checking account each month.
You may need to pay a setup fee when establishing the agreement. The fee can vary based on the installment plan you choose and how you pay. Those with a short-term repayment plan won’t have setup fees; they only exist for those with long-term plans.
Here are the setup fees when you apply for a long-term IRS repayment plan:
Apply online and agree to Direct Pay payments: $31
Apply by phone, in-person or mail and select Direct Pay: $107
Apply online and choose other payment methods such as check, money order or credit card payments: $149
Apply by phone, in-person or mail and choose alternative payment methods such as check, money order or credit card payments: $225
So, if you can repay the debt within 180 days, it may be in your best interest to do so, as it’ll save you money on interest and setup fees. Additionally, depending on your specific financial situation and needs, the IRS may waive the setup fee if you meet the low-income requirements.
What can you do to help ensure repayment?
Taxes shouldn’t come as a surprise. You can do a few things to help ensure you can pay your taxes each year, and if you do have to take out a payment plan, ensure you hit your monthly due dates.
For one, if you receive a tax refund, don't spend it. People are often tempted to spend their refunds on things like a vacation. Consider instead putting it into a savings account. That way, if you do underpay in a future year, you have cash on hand to pay down the balance quickly.
Second, make sure you build a budget and stick to it. Consider tightening your budget a bit come tax season since you know there’s a possibility that you’ll owe taxes to the IRS.
Furthermore, if you have an IRS payment plan, build it into your budget. Prioritize paying back these taxes ahead of things like eating out and entertainment. The sooner you can clear up your debt to the IRS, the more money you’ll save in interest charges.
When examining your budget to ensure you can stick to the agreement, don’t forget to account for the penalties and interest due — you’ll also need to pay those back in your monthly installments. Keep making the monthly payments until you pay off the full amount owed.
If you miss payments or can no longer afford the plan you signed up for, the IRS may penalize you for defaulting on the agreement. At worst, they may cancel the current agreement and take collection actions against you, like filing a federal tax lien as well as levying your wages and bank accounts.
This can have a tremendous knock-down effect. You may not have money to pay bills and could potentially have to take out a personal loan or credit card to cover your living expenses. In these situations especially, consulting with a tax professional could help.
If you reapply for a payment agreement after being canceled, the IRS will ask for an explanation of why you defaulted on your original contract. They may also require you to submit all your financial information for a full review before approving you for another payment plan.
It may be better to set up a payment plan with the minimum monthly payment amount you can afford. If there are months where you can afford to pay more, make extra payments. That way, you don’t default on your agreement but manage to pay it down faster in the months you have spare cash.
Being aware of your taxes can help you avoid penalties and payment plans
Receiving a notice from the IRS that you owe taxes can be stressful. Fortunately, you have the option to resolve the debt by taking action to pay off your taxes by arranging a repayment plan. Of course, if you’re diligent about your withholdings and quarterly payments, you can avoid underpayment penalties altogether.
One of the most important things to consider is sticking to your budget, and freeing up cash in other areas can also help you avoid IRS underpayment penalties. If you currently carry credit card debt that you are looking to get out of, try Tally†. Tally is a credit card payoff app that can help you manage your due dates and pay off your debts quickly and efficiently.
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