Penalty for Underpayment
What happens if you don't pay enough, or don't pay soon enough.
If you don't pay enough estimated tax, or don't pay on time, you'll have to pay a penalty. It's best to avoid this penalty, of course — but you don't have to lose sleep over it. The penalty is equivalent to nondeductible interest on the amount you underpaid, for the period of the underpayment. If you underpay only a small amount, or you correct the underpayment quickly, the penalty will be small.
Nature of the penalty
The penalty for underpayment of estimated tax is figured the same as interest. You determine the amount of the underpayment for each period of time and the number of days in that period, then apply an appropriate interest factor. The interest rate is adjusted from time to time based on market interest rates.
Rates: The rates are available in our Reference Room. As of this writing the most recently announced rate for underpayments (first quarter of 2007) is 8%.
Example: You made estimated tax payments of $4,000 per quarter, thinking that $16,000 would be enough to cover 90% of your tax liability in a year when the prior year safe harbor wasn't available. It turned out that $18,000 was required to cover 90% of your tax liability, so you should have paid an additional $500 per quarter. The amount of your underpayment is $500 for the period from April 15 to June 15, $1,000 from June 15 to September 15, $1,500 until January 15, and $2,000 until April 15 when you filed your return with your payment. The underpayment penalty at the 8% rate in this situation would be roughly $107.
The penalty is not deductible, even if it arises because of investment or business income.
Figuring the penalty
The bad news is that the penalty can be very difficult to calculate. Unless you qualify to use its "simplified method," Form 2210 is not for the faint of heart! The good news is that the IRS will figure the penalty for you. If you don't want to fill out the form, you don't have to do anything about the penalty until the IRS sends you a bill.
Annualized income installment method
There's one special case where it's to your advantage to fill out Form 2210. If most of your income came late in the year, you may be able to reduce or even eliminate your penalty by making a special calculation. This calculation is even more complicated than the regular penalty calculation, but it sometimes reduces the penalty by a substantial amount.
The idea is that you don't have to pay estimates in April, June or September for income you receive in December. If your income is bunched at the end of the year, the calculation will show that you're allowed to make smaller payments for the earlier quarters while making a larger one later in the year. Even if you didn't make a larger payment in September or January, this calculation can reduce the size of the underpayment for the earlier quarters, and that means a smaller penalty.
