Avoid the Shock of a Surprise Tax Bill

Individuals who haven’t kept up with their tax payments may face a hefty surprise this tax season. The Internal Revenue Service (IRS) has escalated the interest on estimated tax underpayments to 8%, a significant jump from the 3% rate two years prior—a direct consequence of rising interest rates that presents a potentially expensive problem for those who are unprepared. This dramatic increase underscores the importance of staying vigilant about your tax obligations.

Who Is Most at Risk of Facing IRS Penalties?

Gig workers, consultants, and individuals without tax withholdings, who are accustomed to settling their tax dues in April, stand to be most affected. However, this risk also extends to those with steady paychecks if their additional income has been miscalculated. Despite the majority of taxpayers benefiting from overpayment refunds due to employer withholdings, the IRS reported over $1.8 billion in penalties from nearly 12.2 million individual returns for underpaying estimated taxes in fiscal year 2022 alone.

The repercussions of underpayment don’t merely end with penalties; they can escalate to higher overall tax bills, risking many Americans’ ability to fully settle their balances come April. Such scenarios could lead to further penalties and, in extreme cases, IRS collection actions like liens and levies. 

The Importance of Paying the Correct Amount

Given the U.S. tax system’s pay-as-you-go nature, making payments as income is earned through withholdings or quarterly tax payments is crucial. The IRS stipulates that most filers must pay 90% of their taxes through these methods during the calendar year to avoid underpayment penalties. Final quarter payments are typically due by mid-January each year, with the IRS providing leniency for balances under $1,000 after withholdings and credits, not enforcing an underpayment penalty.

For individuals experiencing fluctuating or self-employed income, vigilance in estimating taxes is paramount. Unexpected sources of income, like bonuses, high-yield savings interest, and mutual fund distributions, could also subject taxpayers to penalties. A common pitfall is the transition from employed to self-employed status, unaware of the quarterly estimated tax payments requirement.

To mitigate these risks, individuals should consider alternating between paying 90% of the current year’s tax bill or 100% (110% for high earners) of the previous year’s bill, especially if their income varies from year to year. Utilizing tools like the IRS tax-withholding estimator can aid in adjusting withholdings accurately. Moreover, those receiving pensions or taking required minimum distributions have options to adjust their withholding to cover potential tax liabilities.

What If Your Tax Withholdings Aren’t Enough?

By taking immediate action, such as adjusting withholdings or making estimated tax payments, you can significantly reduce the underpayment penalty, properly preparing yourself for future tax filings. Additionally, the IRS offers penalty waivers in specific cases, such as retirement or disability, if the underpayment was due to reasonable cause. This shows that you have the power to take control of your tax situation and potentially save a significant amount of money.

Staying proactive and well-informed about your tax obligations throughout the year is essential to sidestep unexpected tax bills and penalties. The sooner you act, the more likely you are to mitigate surprises come tax season. If you have any questions about your tax responsibilities, contact your CRI advisor. We’re here to navigate you through any complexities, helping ensure you stay on course and avoid penalties.