Federal Tax Filers Beware: Underpayment Penalty Has More Than Doubled

One of the Internal Revenue Service’s fangs has quietly grown much sharper, as the interest rate charged on the underpayment of federal income taxes has soared from 3% to 8% in less than two years. If you’re not sure if you’re hitting the right pace, it’s time to double-check your situation to make sure you don’t throw any more money into Uncle Sam’s rathole than you must. 

While many taxpayers focus on the annual April deadline, the federal income tax actually works on a “pay as you go” basis, in which the government demands recurring bites out of your income, with those bites rising and and falling in proportion to what you’re earning over the course of the tax year. If the math comes out wrong enough when you file, the IRS will penalize you by demanding you pay interest on money you were supposed to have forked out earlier.   

In August, the IRS announced that the interest penalty charged against underpayments was rising to 8% for the calendar quarter that started Oct. 1. The rate isn’t set on a bureaucrat’s whim — per the Internal Revenue Code, it’s calculated each quarter by adding 3% to the “federal short-term rate.” Thus, the higher rate is a reflection of the surge in interest rates. As recently as the first quarter of 2022 — when the Fed’s zero interest rate policy was still in place — the rate was just 3%.  For the first three quarters of 2023, it was 7%.  

Most people whose income is almost entirely derived from regular employment satisfy the pay-as-you-go system through the income tax that employers withhold from each paycheck. Assuming they’ve filled out their IRS W-4 forms correctly, those workers typically don’t run afoul of underpayment penalties. However, regular employees who receive big bonuses or equity compensation might find the regular withholding formula doesn’t cough up enough money to please the IRS. If you want to play with the numbers on your own, you might check out the IRS’s online Tax Withholding Estimator — though ZeroHedge sure isn’t guaranteeing its accuracy. 

For many people, avoiding underpayment penalties requires making quarterly estimated tax payments directly to the IRS, or significantly adjusting their employee withholding. That’s true of anyone with significant income from anything other than regular employment, including the self-employed, gig economy workers, and people with substantial investment income from things like interest, dividends and capital gains. Note: The 2023 surge in yields on money market funds and some bank accounts may cause a surprise underpayment penalty for those who’d grown accustomed to earning near-zero on their cash. 

Federal tax rules provide for a “safe harbor” that generally guarantees you from facing underpayment penalties on personal tax returns. You won’t have to pay the penalty if your withholding and/or timely estimated taxes add up to at least 90% of your 2023 tax bill or 100% of what you owed in 2022. However, if your adjusted gross income is more than $150,000 (or $75,000 for married couples filing separately), the safe harbor linked with your 2022 tax bill rises from 100% to 110%.  

The IRS is notorious for complicating taxes at every turn, and estimated tax is no exception. Here, the IRS assigns four due dates that don’t come every three months. Instead, payments are due April 15, June 15, September 15 and January 15. (This year, the payment for the fourth quarter instead is due Jan. 16, 2024.) There are several methods for making payments, including mail or through on online portal. 

In fiscal 2022, the IRS hit individual taxpayers for more than $1.8 billion in underpayment penalties — a number that’s likely to soar alongside the rising penalty interest rate. Here’s hoping ZeroHedge readers aren’t victims of the Feds’ upcoming feeding frenzy.