Happy tax day, everyone! How did your tax situation end up? Did you owe more than you expected or worse... Did you have to pay an underpayment penalty (line 38 on your 1040)? This blog will explain how the federal U.S. tax system works, why taxpayers face underpayment penalties, what they are, and how best to avoid them.
How does the U.S. tax system work?
In the United States, our income tax system requires each individual to pay their taxes as they earn income throughout the year. This means that even if you made a lump-sum payment on December 31st for all of the taxes you owe in a year, you could still potentially pay an underpayment penalty for not keeping up with your tax obligations throughout the year.
This can be done through tax withholdings if you are a W-2 employee or through quarterly estimated tax payments if you are a contractor or self-employed individual, or if your W-2 withholdings are insufficient.
What happens if you don’t pay enough taxes throughout the year?
You could face an underpayment penalty if you do not pay enough taxes throughout the year. This is not a friendly penalty and is generally avoided by taxpayers with W-2 income. If you are self-employed, then you must especially keep on track with your estimated tax payments throughout the year to avoid the underpayment penalty.
The underpayment and late payment penalties currently have an interest rate of 8% as of April 2024 until the balance is paid off. This interest rate hasn’t been this high since 2007! This means it will cost you more today to pay these penalties than it has in the last 15 years. It can simply be avoided by making better financial decisions throughout the year (that’s something we’re experts in!).
How can you avoid paying penalties during tax season?
Taxpayers can avoid the underpayment penalty if they either have less than $1,000 as a federal tax liability or if they paid taxes for at least 90% of the tax for the current year or 100% of the taxes owed on the return for the prior year, whichever is smaller (IRS).
This blog specifically addresses how to avoid underpayment penalties for federal purposes. Your state, like the state of California, may have a different set of rules!
For a self-employed person, the best thing you can do is anticipate how much income you can expect for the year and commit to making quarterly estimated tax payments to the IRS. The quarterly tax payments should be based on the income or revenue generated in that quarter.
The confusing thing here is that not all quarters are exactly 3 months apart. Federal tax payments are due on April 15th (Jan 1st - March 31st revenue/income), June 15th (April 1st - May 31st revenue/income), September 15th (June 1st - August 31st revenue/income), and January 15th (September 1st - December 31st revenue/income).
Pay very close attention to when your payments are due and for what months!
How can you be better prepared for the 2024 tax year?
You need to create a financial plan that accounts for your federal (and state!) tax obligations. At Fyooz Financial Planning, we take tax planning very seriously. We help our self-employed clients stay ahead of their quarterly tax payments by partnering with their accountants along the way. We also help our clients with large restricted stock vesting and capital gain liquidations make tax payments each quarter to stay ahead.
If you need more organization with your financial plan and tax obligations, consider scheduling your free consultation with us today. Each summer we conduct a mid-year tax analysis with our clients to create tax planning strategies to potentially lower their projected tax liabilities and avoid underpayment penalties. Let us help you get ahead of your taxes for 2024!
Disclaimer: This article is for informational purposes only and is not a recommendation of Fyooz Financial Planning, Natalie Slagle CFP®, or Daniel Slagle CFP®. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment or financial planning strategy. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.
