How to avoid underwithholding -- and its penalties

In our pay-as-you-go tax system, the IRS expects to get its money regularly throughout the year as you make money. If you have too little tax withheld on the job, or have income from sources where no tax is withheld, you could be hit with penalties and interest charges for underwithholding.

The easiest way to avoid the penalties is to keep track of how much tax you have withheld and file a new W-4 to increase your withholding if necessary during the year. If you have income from other sources -- a lot of interest income or a second job where you are paid as a contractor and not as an employee -- you might need to pay estimated taxes to avoid an underpayment penalty.

Underwithholding costs: If you haven't paid your taxes or paid too little during the year, the IRS will charge interest on the money it decides you should have sent in earlier. The interest is compounded daily and begins on the day the taxes were due and continues until the agency gets the money. The interest rate is variable, based on the federal short-term rate plus 3 percent, and is recalculated every three months.

In addition to the interest charged on unpaid taxes, the IRS also can hit you with a penalty if it decides you were really bad. There is a late payment charge of 0.5 percent of the tax owned for each month -- or any part of it -- that your tax is unpaid after its due date. This penalty can increase up to 25 percent and can increase in 1 percent increments if you don't pay after getting several notices from the IRS.

There is a $500 civil penalty for underpayment of withholding if you claim W-4 allowances you knew you weren't entitled to and those allowances reduced the tax taken out of your pay.

And you could face criminal charges if you enter false W-4 information. This charge also applies if you fail to change your W-4 when necessary to appropriately increase your withholding. If convicted, you could be fined as much as $1,000, be jailed for up to one year, or both.

These penalties apply to intentional falsification of a W-4 in an attempt to reduce or eliminate withholding taxes. If you make a simple error -- an honest mistake – you won't face prosecution. For example, a person who has tried to figure the number of withholding allowances correctly, but claims seven when the proper number is six, will not be charged.

Estimated tax payments and penalties: If you have income where no tax is withheld, you are responsible for paying that tax yourself. You do this by paying estimated taxes. You must figure the amount of income you expect to earn from this untaxed source and pay estimated taxes payments each quarter: April 15, June 15, Sept. 15 and Jan. 15 of the following year.

The quarter due dates are important. As withholding demonstrates, the IRS requires taxes to be paid on income as that income is earned. That means if you earn $4,000 a year you must determine when you got the money -- say, $1,000 in the first quarter (January-March), $500 in the second (April-June), $2,000 in the third (July-September) and $500 in the fourth (October-December) and pay the appropriate taxes for each period. You cannot wait until the fourth quarter due date of January and pay taxes on the full $4,000. If you do, it means you paid your first three quarters of taxes late -- and you face interest and penalties charges.

Even when you make the quarterly payments properly, you still could face extra costs if you owe more than $1,000 when you file your return. The penalty for underpayment of estimated tax is figured at an annual percentage rate times the number of days the tax remained unpaid.

You can avoid a penalty for underpayment of estimated taxes if you meet a "safe harbor" payment amount: the smaller of 90 percent of what is ultimately owed or a percentage of the taxes you paid in the previous year. If you make less than $150,000 the safe harbor is 100 percentage of the previous year's taxes. If you make $150,000 or more, the prior-year safe harbor percentage is more than 100 percent. The exact amount varies each year, so check out the latest version of IRS Publication 505 for details.

Waiver of penalties: If you thought you had your withholding figured correctly and made the estimated tax payments but still came up short, you can request a waiver of any penalty by filing Form 2210. The IRS may waive the penalty for underpayment if:

You missed a payment because of a casualty, disaster or other unusual circumstance.
You retired after reaching age 62 or became disabled during the tax year a payment was due or during the preceding tax year.
Your missed payment must have been unintentional and you must show a good reason for missing the payment.

Article from Bankrate.com