It’s December. Most are thinking about Christmas and presents. Me – I’m thinking about taxes… Did I earn more than I thought I would this year? Did I underpay my taxes? Will I get penalized if I underpaid? What IS the underpayment penalty rate?? All these thoughts race through my head as I scribble down some figures on a well-used piece of paper, just trying to figure the whole thing out before I sit with my tax guy and get the terrible news…
Maybe you’re in the same boat. Maybe you’ve got a full-time job like I do, but then you also have a side hustle that brings in a decent amount of money. At the end of the year, you start to wonder… Did you pay in too much? Or too little? And what happens if you underpay?
It’s time to solve the riddles….
What Happens If You Underpay Your Taxes? The Underpayment Penalty Rate…
Liz and I have three solid income streams:
- My full-time job
- This blog
- A single-family rental
We are a family of four and could probably claim 4 allowances (or more) on our W-4. But, since we earn some extra cash with the blog and the rental, we just claim zero and pay in more tax on the day job, which inherently covers additional taxes that we would have otherwise owed on the rental and blog. This saves us from figuring out quarterly estimates and writing all the extra checks.
However, since this method is incredibly non-scientific, it really gets me wondering/paranoid at the end of the year!
If my blog has an unbelievably good income year (like I had this year), I really start to worry! While I do have the cash to pay additional taxes, it still doesn’t feel good to owe money. And, I certainly don’t want to pay a penalty on my tax underpayment!
How to Figure Out If You’ve Overpaid or Underpaid
So first thing’s first. How do you even figure out if you’re headed toward an underpayment on your federal taxes? It’s not super simple, but pretty much anyone can do it.
You’ve got your tax forms from last year right? Either you filled them out or your accountant did.
- They record your income from your day job, your investments, your side hustles, etc.
- They’ve got the amount of taxes you paid in
- There’s also all your deductions (which probably don’t change from year to year)
Now, all you have to do is tweak some of the numbers and carry the calculations through.
- For me, I had to update my day-job income (I got a slight promotion)
- The rental income was roughly the same, but I did have to update my expenses – they weren’t quite as high as they were the last year
- And, I had to bump up my blog income by like…$15,000 (it was a great year for blogging!!)
I put all the new numbers into the main-page calculation and…. it said that I would be underpaid on my taxes by roughly $1,500…and I would therefore have to succumb to the underpayment penalty rate (which, as far as I understand it, kicks in once you’re underpaid by more than $1,000)…
What You Can Do About It
The nice thing about figuring out your tax bill now is that you still have a couple weeks to do something about it. Meaning, you can still load up a few pre-tax accounts, which lowers your taxable income, which means you’ll bring down the number for what you owe in taxes.
For example, let’s say you earned $70,000 as a couple this year. You’re in the 12% tax bracket, and let’s say you underpaid into your taxes by $1,000…
…but you kind of forgot to invest or put any money into your health savings account.
If you have a bit of savings that can float you for a bit, or if you live far below your means, now is the time to make some serious deductions from your paycheck.
- Increase your deduction rate for your traditional 401(k) (pre-tax) – say from 10% up to 25% or maybe even 50%
- Increase your deduction rate for your HSA – maybe from $50 per paycheck to $500 per paycheck!
Yet Another Option
If you have a business or side gig that you pay taxes on, you can also start looking at your expenses and consider investing more heavily into it before the year ends. As an example, for my website I recently decided to switch web hosts for better up-time and speeds. This costs me extra this year (which reduces my income, and therefore my taxes owed), but it should improve my profits in the future. So it’s a win-win!
If you’re under-paid in taxes right now and might be facing the underpayment penalty rate, then perhaps you should:
- Increase your pre-tax investments, or
- Invest more heavily into your business before year end!
The Penalty If You Didn’t Quite Pay in Enough
Alright…we’re finally getting to it – the underpayment penalty rate. Sorry for my long-windedness… But, I figure that if you can get away with not paying a penalty, that’s better than even knowing what the rate is!
According to the IRS…
“If you didn’t pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax. Generally, most taxpayers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and refundable credits, or if they paid withholding and estimated tax of at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller.”
And as for the actual underpayment penalty rate…as you may have guessed, it’s kind of complex…
Based on Form 2210, “Underpayment of Estimated Tax by Individuals, Estates, and Trusts”, the underpayment penalty rate is 3.603% of the amount that you underpaid. So, if you underpaid by exactly $1,000, you owe an additional $36.30.
…There’s yet another clause (of course).
If you paid your taxes before April 15th, you can reduce this penalty by 0.016% each day. So, let’s say you paid your taxes on March 15th, roughly 30 days earlier. You get to reduce your tax penalty by 0.48% (0.016%*30 days).
So, instead of paying a penalty of 3.603%, you now owe 3.123%…which equates to $31.23.
The Underpayment Penalty Rate – It’s Hardly Worth Worrying About…
So….$30, huh? Instead of owing the government $1,000, you now owe them $1,030… Big whoop. There’s honestly more risk in just paying the government too much money than there really is in underpaying your taxes and paying the underpayment penalty rate.
I suggest you do your due diligence in December. Instead of worrying about presents for just one day, worry instead about how much you’re actually paying in to the government. You can still impact the results!!
What do you do to limit your tax liability? Are you doing a quick calculation this year to ensure your tax payments were accurate?
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.