The Internal Revenue Service employs both a short and a regular method to calculate the penalty for underpaid taxes. The short method applies a penalty of 1.995 percent on the underpaid amount for the year. If you pay the underpaid amount before April 15 of the year following the filing, multiply the number of days before April 15 by 0.00008 and subtract the result from the penalty. The regular method is more complex and might result in a lower penalty.
Pay as You Go
The federal government uses a pay-as-you-go income tax method, which means that you pay taxes soon after you receive taxable income. Employers withhold income tax when paying salary, wages and other compensation to employees. The withheld amount is based upon Form W-4, which employees file to declare tax-reducing allowances and exemptions. Brokers and other payers may also withhold taxes. Self-employed individuals don't use withholding, but rather shell out quarterly estimated taxes using Form 1040ES. Employees can also use Form 1040ES to fork over under-withheld taxes.
Avoiding the Penalty
You're not liable for the underpaid tax penalty if the sum of your withholdings and estimated payments equals at least 90 percent of the current year's tax or 100 percent of your previous year's tax, whichever is smaller. You're also off the hook if your total tax minus withholding was less than $1,000 or if you had no tax liability in the previous year. Finally, you won't incur a penalty if you didn't have any withholding taxes and your total tax bill is less than $1,000 after subtracting any household employment taxes you withheld for maids, nannies, babysitters and other people you employ.
Other Penalty Situations
If you negligently overstate your allowances and exemptions on Form W-4, you may have to pay a $500 penalty -- unless you did so in an attempt to defraud, which is punishable by a fine of $1,000 and/or a year in prison if you're convicted. The IRS can assess interest if you do not promptly pay your underpayment penalty and the tax owed. The underpayment interest rate is compounded daily and determined quarterly, equal to the federal short-term rate plus 3 percent. You may also have to pay a failure to pay a penalty of 0.5 percent per month, up to 25 percent, on the amount owed. The penalty increases to 1 percent per month if you don't repay within 10 days after receiving an IRS levy notice, which allows the IRS to seize your property.
The IRS provides for reduced underpayment penalties if you are a farmer or fisherman. You might get the IRS to waive the penalty if you underpaid because of a disaster, death or other unusual circumstance. The IRS might also waive the penalty if you became disabled or you retired after reaching age 62, and your failure to pay was not the result of willful neglect.
You can use IRS Form 2210, Underpayment of Estimated Taxes by Individuals, Estates and Trusts, to calculate the underpayment penalty using the short or regular methods. You may have to figure your penalty and file the form if you are requesting a waiver or if other circumstances apply that might lower the penalty amount. Otherwise, you don't have to the file the form, because the IRS will figure the penalty for you.