How Underpaying in Taxes is Now Costing You More
When it comes to taxes, underpaying the IRS can be costly. In recent years, the cost of underpaying has gone up substantially.
Rising IRS Interest Rates
One primary reason underpaying taxes is more expensive is the rising interest rates on unpaid taxes. The IRS charges interest on any tax owed, just like a loan from a bank. These rates are adjusted quarterly and are tied to current interest rates.
As with other forms of debt, this rate has also increased. As of January 2025, the rate is 7%, up from 3% a few years ago.
This means if you owe back taxes, you're effectively taking on high-interest debt by waiting to pay it.
Additional Penalties
Beyond interest, the IRS adds penalties for underpaying. The penalty is calculated based on the amount underpaid, the period it was underpaid, and the IRS interest rate.
Avoiding Underpayment: The Safe Harbor Rule
You can rely on the IRS's safe harbor provisions to avoid underpayment penalties. You must meet one of the following criteria, but you can choose the one that results in the lowest tax withholding.
You owe less than $1,000: The IRS does not enforce interest and penalties if the amount owed is less than $1,000.
Example - Your federal tax bill is $50,000, and you withhold $49,300 (less than $1,000 difference).
Pay 90% of your current year's tax: Estimate your total tax obligation for the year and ensure at least 90% is paid via withholding or quarterly payments.
Example - You are married, and AGI is $200,000. Your federal tax bill is $40,000, and you withhold $36,000 (90% of $40,000).
Pay 100% of your prior year's tax liability (INCOME RESTRICTION APPLIES): Pay at least 100% of your prior year’s tax via withholding or quarterly payments. **You can only use this method if your adjusted gross income (AGI) is under $75,000 as a single filer or $150,000 married.
Example - You are married, and AGI is $140,000. Your federal tax bill is $20,000, but last year it was only $15,000, and you withhold $15,000 (100% of the prior year’s $15,000).
Pay 110% of your prior year's tax liability (FOR HIGHER-EARNERS): Pay at least 110% of your prior year’s tax via withholding or quarterly payments. It is raised from 100% to 110% if your AGI is over $75,000 as a single filer or $150,000 married.
Example - You are married, and AGI is $200,000. Your federal tax bill is $40,000, but it was only $20,000 last year, and you withhold $22,000 (110% of the prior year's $20,000).
**Estimated taxes are calculated quarterly, so if your income is received unevenly, you may need to adjust quarterly payments.
One of the simplest ways to ensure no interest and penalties is to review your paystubs from work, pensions, social security, and other income sources and see if you are tracking toward 100% (or 110% if higher income) of your prior year’s income.
But remember, even if you don’t owe any interest and penalties, you still owe the taxes, which can disrupt normal cash flow! Using the IRS tax software or working with a professional to help estimate income and withholdings can help avoid this!
Happy Planning,
Alex
This blog post is not advice. Please read disclaimers.