Tax penalties can be daunting, but they don't need to be confusing. Here's how you can minimize or avoid the most common penalties imposed by the IRS.
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Saving on penalties
Things don't always go as planned when it comes to filing your tax returns and paying your taxes on time. Even if you have the best intentions, you might face an IRS tax penalty for underestimating your quarterly payments, missing a tax filing deadline, or bouncing a check to the IRS.
Mistakes happen, but it helps to know the types of penalties the IRS charges and how they're calculated. It's also a good idea to know your options if you've been penalized by the IRS.
Common tax penalties
Here are four common tax penalties the IRS charges taxpayers, as well as tips for avoiding them.
Failure to file
This year, tax returns are due on April 18, 2023. If you need more time, you can request an extension, which gives you until October 15 to file your return. If you don't request an extension or miss your extended due date, the IRS charges a failure to file penalty.
This tax penalty is 5% of the unpaid tax for each month or part of a month that your return is late. However, it caps at 25% (5 months) of your balance. If your return is more than 60 days late, a minimum penalty applies. The minimum penalty is either $435 or 100% of the tax owed, whichever amount is less, for returns due after 1/1/2020.
To avoid a failure to file penalty, make sure you file your return by the due date (or extended due date) even if you can't pay the balance due. You have a little more leeway if you're expecting a refund. In that case, the IRS won't charge a failure to file penalty if you file your tax return late. However, you can lose your refund if you don't file your return within three years of the original due date.
Failure to pay
Whether you file your tax return on time or request an extension, the IRS requires you to pay the tax due by the filing deadline. If you don't pay what you owe by that date, the IRS charges a failure to pay penalty.
This tax penalty is 0.5% of the tax you owe per month, but it also caps at 25% of the tax due. If you set up an IRS installment agreement, the IRS will reduce your failure to pay penalty to 0.25% of the tax you owe while the installment agreement is in effect.
Both the failure to file penalty and the failure to pay penalty are charged for a full month, even if you pay the balance due before the month ends. When both the penalties apply to the same month, the failure to file penalty is decreased by the amount of the failure to pay penalty so that the maximum combined failure to file and failure to pay penalty is 5% for any month.
To avoid or at least minimize failure to pay penalties, pay your tax in full by the tax deadline, even if you request an extension. If you owe more than you can afford to pay, pay as much as possible by the deadline, then pay the rest as soon as you can. If you cannot pay the rest that you owe within a few months of the due date, you should look at requesting an installment agreement.
Failure to pay proper estimated tax
The IRS has a "pay as you go" system, which means you're supposed to pay taxes throughout the year as you earn or receive income, rather than sending a big lump sum to the IRS at the end of the year.
If you owe more than $1,000 when you calculate your taxes, you could be subject to a penalty. To avoid this you should make payments throughout the year via tax withholding from your paycheck or estimated quarterly payments, or both.
The IRS calculates this penalty by figuring out how much you should have paid each quarter and multiplying the difference between what you paid and what you should have paid by the effective interest rate for that period. This means you can have a penalty for one quarter, but not the others.
To avoid or minimize estimated tax penalties, adjust your tax withholding from your paycheck or estimate your tax bill and make estimated quarterly payments. Those quarterly estimates are typically due on:
- April 15
- June 15
- September 15
- January 15
However, if one or more of those dates fall on a weekend or legal holiday, the deadline gets pushed back to the next business day.
The IRS also offers two "safe harbor" methods for determining whether you are subject to a penalty. If you meet one of these safe harbor amounts, the IRS won't charge an estimated tax penalty, even if you owe more than $1,000 at the end of the year.
The requirements are that you pay:
- 90% of the tax you owe for the current year. Estimate what you'll owe and pay at least 90% of this amount in four equal installments or through paycheck withholding.
- 100% (or 110%) of last year's tax bill. Pay 100% of the tax shown on your prior-year tax return before applying estimated payments, withholding, or refundable tax credits. If your adjusted gross income is more than $150,000 (or $75,000 if you're married and file a separate return from your spouse), the safe harbor is 110% of your prior-year tax.
If you write a check to cover your tax bill and don't have enough money in your bank account to cover it, your bank may dishonor or "bounce" the check. The IRS charges a dishonored check penalty of 2% of the check's amount unless it's less than $1,250. In that case, the penalty is $25 or the amount of the check, whichever is lower.
To avoid a dishonored check penalty, make sure you have funds in your account to cover your payment before mailing a check. Or, sign up for overdraft protection with your bank.
How to get tax penalties removed
In a perfect world, you'd never have to deal with IRS penalties. Unfortunately, tax penalties are a reality for many people. Fortunately, the IRS is often willing to work with people who make mistakes. This process is known as penalty abatement.
There are two common reasons the IRS might consider penalty abatement.
1. Reasonable cause
If you didn't file on time or pay the tax you owe due to extenuating circumstances, the IRS might agree to waive your penalties. Examples of reasonable cause might include a house fire, natural disaster, illness, or an immediate family member's death.
2. First-time penalty abatement
If you're normally on top of your tax filing responsibilities but just missed the filing deadline or payment due date, the IRS may do you a one-time favor. To qualify, you must have filed all of your tax returns, pay your outstanding balance or set up an installment agreement with the IRS, and have no prior penalties in the past three years.
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