How to Avoid the Penalty for Underpayment of Estimated Tax

September 20, 2017 | By: Stephanie Taylor Christiansen

How to Avoid the Penalty for Underpayment of Estimated TaxThe estimated tax penalty is technically called an underpayment penalty. More than ten million taxpayers paid underpayment tax penalties in the 2016 tax year, compared to the 8.9 million who paid them in 2014. That increase may have something to do with the estimated 30% of working-age people the Chicago Tribune reports are now part of the so-called “gig economy.”

If you rely on freelance or contract work as a means of primary income or earn extra cash with a side hustle in addition to a traditional 9 to 5 gig, your untaxed income may require that you familiarize yourself with a new set of tax laws.

Here’s what you need to know or how to avoid the penalty for underpayment of estimated tax when you officially file your annual tax return.

Determine Income Streams Subject to Estimated Tax Payments

The tax laws for those in the gig economy can be easy to misinterpret, especially if you don’t generate a significant amount of income with a side gig. However, an innocent misunderstanding can eventually mean underpayment penalties and fines.

Per the IRS, individuals, sole proprietors, partners, and S corporation shareholders should make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed; corporations should make estimated tax payments if they’ll owe more than $500. In addition to money earned in the gig economy, estimated payments may also be owed on untaxed financial “windfalls” related to gambling winnings, investments, or even, alimony.

Estimate What You Should Pay Each Quarter

If you earn untaxed income throughout the year, the IRS generally wants estimated tax payments four times a year.  (This is true even if you receive a tax refund when you file your annual tax return). To calculate how much in estimated taxes you should pay each quarter, estimate the amount of the untaxed income you expect to receive in the tax year, minus any deductions or credits you’ll claim relative to it. Divide the number by four to calculate the estimated tax payment amount. If you have a full-time job, you could also increase the amount of tax you have withheld from each paycheck to ensure you pay adequate taxes throughout the year.

If you earn significantly more than you anticipated over the course of the tax year, you can increase your quarterly tax payments. The IRS encourages tax payments to be in four equal installments, but if income increases unexpectedly, that may not be possible. To avoid the underpayment penalty, increase your quarterly payment to accurately reflect your earnings.

Submit Quarterly Payments on Time

The due dates for when estimated quarterly payments fluctuate somewhat each year, but generally fall on or near the 15thof the month in April, June, September, and January (of the following tax year). You can mail your estimated tax payment with a check and printed Form 1040-ES estimated payment voucher, or electronic funds transfer online via EFTPS. The IRS also accepts tax payments by phone, and using a credit or debit card, but service fees do apply.

Dedicate Part of Your Earnings to Estimated Taxes

The tax system is based on a “pay as you earn” basis. Therefore, apply the same rules to your personal finances so have the money you need to pay estimated taxes by the quarterly due date.  If your income fluctuates greatly in your side gig, or you’re just getting started in the gig economy and don’t know how much you’ll earn, save at least 15% of your monthly untaxed earnings for your estimated tax payments. When you file your annual tax return, you’ll report the estimated tax payments you’ve made throughout the year, to accurately calculate any tax you still owe or are owed  in the form of a tax refund.

Determine If You Qualify for Exemptions

The IRS does waive the underpayment penalty in some circumstances, including qualifying disasters. This includes those impacted by recent floods, tornados, and hurricanes.  Taxpayers who were unable to pay estimated taxes due to other unusual circumstances can file Form 2210, to request that the IRS waive an underpayment penalty.

Summary of How to Avoid the Penalty for Underpayment of Estimated Tax

Remember, the U.S. tax system has a pay as you go structure. In order to avoid the underpayment penalty is a good idea to pay estimated taxes quarterly (although you can pay monthly or weekly). Most taxpayers will avoid this penalty if:

  1. The taxpayer owes less than $1000 in tax after taking into consideration withholdings and estimated tax payments or
  2. The taxpayer paid the smaller of at least 90% of the tax owed (66 2/3% for farmers and fisherman) for the current year or paid 100% of the tax shown on the tax return for the previous year (2016 return must cover 12 months).
  3. Note: If the taxpayer has an AGI of $150,000 or more ($75k for married filing separately)and less than 2/3 of gross income is from fishing/farming, the 100% number above becomes 110%.

Remember, if you are a U.S. citizen or resident that had no tax liability in the prior year, you are not be required to make estimated tax payments in most cases.