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The three most common IRS Penalties

IRS Penalties

The government wants it’s money, and they want it on time. If you are late filing or paying your taxes, you will owe the IRS big! In some cases you may owe the IRS as much as 47.5% more than what you originally owed in tax! We are going to go over the three (3) most common penalties the IRS assesses, and how you should avoid them.

  • Underpayment Penalty
  • Failure to file your tax return on time
  • Failure to pay your taxes on time

Underpayment of tax

Underpayment of taxes (sometimes called “Estimated Tax Penalty“) is a penalty the IRS came up with to make sure you are sending the government money throughout the year and not just once on April 15th. In order to figure out what your underpayment penalty is the IRS looks at your prior year tax return.

They first look at if you owe over $1,000 in tax. If you owe under $1,000, there is no underpayment penalty. If you owe over $1,000, they figure out the minimum you need to send them by calculating the lessor of:

  • 90% of what you owe for the current year, or
  • 100% of what you owed last year.

Here’s an example: let’s say that Steve owes the IRS $22,000 in tax in the current year and he owed $20,000 of tax last year.

He would need to send in at least $19,800 (90% of the current year is $19,800, which is less than what he owed last year, $20,000).

In order to avoid the underpayment penalty, the IRS expect you to send in payments quarterly. But guess what? You need to send in payments based on the Federal Governments budget (not normal 3 month quarters). The quarterly tax payment dates are:

  • First payment – April 15th,
  • Second payment – June 15th,
  • Third payment – September 15th,
  • Last payment – January 15th of following year
  • Final payment (any remaining amount due) – April 15th of following year

The penalty for underpayment is 3.4%, but gets reduced if you pay before your final April 15th payment. Avoid this penalty and send in payments quarterly. You should be able to get quarterly payment vouchers from your CPA or tax preparer. There is no reason to send the IRS extra money.

Filing late tax returns

Commonly known as the “Failure to File” penalty. CPAs and tax preparers hate this penalty since it is so large and abusive. The penalty is 5% each month of what you owed, maxed out at 25% per year. So if you owe $10,000 in tax, you may owe an additional penalty of $2,500 per year if you file late. If you extend your tax return, you avoid this penalty. If you forget to extend, the IRS will get you! Try to avoid this penalty at all costs.

This penalty is so bad that many tax preparers will file incorrect returns on time, and then go back and file correct amended returns later just to avoid this penalty.

Since this is one of the worse penalties that the IRS came up with, you should always file your taxes on time. If you need more time, extend your tax return. Never, not file your return, otherwise the IRS will take more than you owe!

Paying your taxes late

Any tax not paid by April 15th get’s hit with the Failure to Pay penalty. Extending your tax return does not save you. Not as bad as the failure to file penalty since it’s 0.5% per month, maxed out at 25%. A few things about this penalty to keep in mind:

  • Penalty is normally 0.5% monthly
  • Installment agreements (a.k.a. IRS payment plans) will drop your penalty to 0.25% per month.
  • If you avoid the IRS and make them send you an intent to levy notice, the penalty goes up to 1.00% per month.

If you are assessed the failure to file penalty, you will also get hit with the failure to pay penalty at the same time. The max amount of both penalties in the same year is 47.5%!

Make sure you pay all your taxes by April 15th to avoid this penalty.

Interest on top of penalties

Not only does the IRS hit you with penalties, they also get you with interest. That’s right, most IRS penalties incur interest on top of them, and they’re not cheap! Important things to keep in mind about the IRS’ Interest calculations:

  • The interest rate is updated quarterly,
  • It’s 3.00% + the Federal Short-Term rate,
  • IRS interest is compounded daily!

Do I have penalties if the IRS owes me money?

Penalties are normally assessed only when you owe the IRS money. If the IRS owes you money, there are usually no penalties. Even if you file your taxes late. That’s right, if you are entitled to a refund, there are no penalties.

Penalty Example

I once had a client that hadn’t filed her taxes for 5 years. She got a new corporate job. Within two week of being hired the IRS sent a letter to the HR department telling them to garnish her wages. She hired me to go and back file her late tax returns. Below is a chart of how much she originally owed, vs what she owed plus penalties and interest when IRS caught up with her.

YearTaxes DueTaxes + Penalties + Interest
1$4,671$8,358
2$3,692$6,202
3$2,058$3,249
4$2,839$4,169
5$4,084$5,545
Totals$17,344$27,523

She owed an extra $10,179 in penalties and interest. And the penalties and interest continued to accrue until she paid her balance off in full.

How do I pay the IRS?

We wrote a great article on how to pay your taxes here.

Remember to do whatever you can to avoid penalties and interest. You should never give the IRS more money that you ever have to.