The Internal Revenue Service (IRS) is intensifying consequences for individuals who fall short in paying their taxes, escalating the interest penalty slated for assessment in the upcoming tax filing season next spring.

In recent months, the IRS has heightened the interest penalty for underpayments in estimated taxes to 8%, a significant increase from the 3% rate observed merely two years ago. According to legal requirements, the IRS is obligated to recalculate the interest rate penalty quarterly. For taxpayers, excluding corporations, the assessed rate comprises the federal short-term rate plus an additional three percentage points.

Individuals, particularly self-employed workers and independent contractors, encompassing many gig workers, face the risk of incurring the underpayment penalty if they neglect to settle the amount the IRS deems owed. It’s important to note that taxpayers won’t be subject to an interest penalty for underpayment if the outstanding balance is less than $1,000 after factoring in credits and other tax account details.

Workers falling under this category must fulfill the obligation of making estimated tax payments at least once every quarter if their regular pay periods do not entail withholding at least 90% of their taxes. As an illustration, individuals adhering to this payment arrangement will need to submit their estimated payment for the fourth quarter of 2023 by January 16, 2024.

These alterations will not impact the majority of taxpayers categorized as W-2 employees who have tax payments automatically deducted from each paycheck. In most instances of such arrangements, taxpayers end up being eligible for a tax refund rather than being subject to an underpayment penalty.

Sameet Durg, a marketing executive, encountered a shock when he visited Doerrer to have his taxes handled. He discovered that he owed a substantial underpayment penalty, amounting to thousands of dollars, along with a hefty tax bill in April. This was due to his failure to make periodic estimated payments on taxes owed from his consulting income.

Reflecting on the experience, Durg shared with the Journal, “Now I stay vigilant about taxes throughout the year. I want to avoid the significant hit come April.”

TIPS

Avoiding underpayment penalties is crucial for gig workers. For instance, a gig worker with a $10,000 tax liability who fails to make quarterly estimated payments of $2,500 could incur a $512 underpayment penalty, in addition to the tax bill due on April 15, according to Chris Oliva, a CPA at UHY Advisors in New York City. The penalty calculation, outlined in Form 2210, utilizes a blended interest rate for the tax year 2023.

To shield themselves from underpayment penalties, individual taxpayers can generally ensure they pay in (through withholding or estimated taxes) at least 90% of the current year’s tax bill or 100% of the previous year’s tax bill. The 100% threshold increases to 110% for filers with an adjusted gross income exceeding $150,000, or $75,000 for married taxpayers filing separately.

Adopting a strategic approach is advisable, especially when income is uneven. For instance, toggling between paying in at 90% and 100% makes sense for those experiencing high-income followed by low-income years. This avoids unnecessary overpayments. Conversely, individuals facing a low-income year followed by a high-income year may find it beneficial to pay 100% or 110% of the penalties.

Changing withholding to increase take-home pay can backfire, warns Karla Dennis, a La Palma, Calif., enrolled agent. Instead, making estimated tax payments, preferably early, can minimize underpayment penalties, as the penalty amount involves a daily calculation.

In cases where additional withholding isn’t feasible, gig workers can consider paying electronically through IRS Direct Pay or by setting up an account with the Treasury Department’s Electronic Federal Tax Payment System.

For those facing financial constraints, requesting a penalty waiver is an option. The IRS may waive estimated tax penalties in specific situations, such as for retirees after reaching age 62 or individuals who became disabled, provided the underpayment arose from reasonable cause.

Utilizing tools like the IRS tax-withholding estimator helps taxpayers adjust their withholding appropriately. This involves inputting information from the previous year’s tax return, pay stubs, and other income sources, including side gigs, investments, and retirement account payouts.

Employees withholding too little can modify their recurring tax withholding by completing a revised Form W-4 with their employer or withholding an additional dollar amount. This is particularly relevant for those taking required minimum distributions from an individual retirement account, where choosing a higher withholding amount for those distributions can help avoid or minimize underpayment penalties. The IRS treats the extra withholding as evenly spread throughout the year, providing a more balanced approach to meeting tax obligations.

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