Estimated Tax Penalty: What Is It and How To Avoid It

As a freelancer, you've certainly heard the cliche be your own boss. With great power comes great responsibility is another cliche, and in this case it includes taxes.

For you, taxes aren't just a once-a-year headache. Self-employed individuals must pay estimated taxes four times a year.

The deal with quarterly taxes is that many freelancers skip estimated tax payment deadlines, which leads to hefty fines. To make sure this doesn't happen to you, here's everything you need to know about estimated taxes and the penalties for not paying.


What are estimated taxes?

Taxes in the US work on a pay-as-you-go basis, which means the IRS collects income tax throughout the year via your employer's payroll. If you're a W-2 employee, your employer automatically withholds your taxes, but if you're a freelancer, you'll have to do the math independently once every three months.

These quarterly estimated tax payments, also known as quarterly taxes, are required by the IRS if you owed $1,000 or more when you filed your last annual return. Similarly, corporations that expect to owe at least $500 to the government in annual taxes must pay quarterly taxes.

Timeline for estimated taxes

These estimated tax payments (reported on form 1040-ES) are due on a timeline.

Usually, the estimated tax due date falls on the fifteenth of April, June, September and January. But for the year 2022, the due dates are slightly different.

The table below represents the quarterly tax due dates for 2022.


Who has to pay the quarterly estimated taxes?

Self-employed individuals have to pay quarterly estimated taxes if they expect to owe at least $1,000 in taxes.

Not all freelancers and independent contractors need to pay quarterly taxes. FlyFin's quarterly tax calculator estimates whether you owe quarterly taxes and if you do, how much.

Who else has to pay quarterly taxes?

Estimated payments also apply to taxpayers who earn money that isn't subject to withholding. That can happen if the money is being made via:

  • Business earnings
  • Dividends
  • Interest
  • Taxable alimony
  • Gains from the sale of assets (e.g. stocks)

However, estimated tax payments are usually associated with freelancers and small business owners.

Types of tax penalties

  • Failure to pay penalty
  • Underpayment penalty
  • Failure to file penalty

If you manage to pay and file your taxes on time, you need not worry about penalties, unless you underpay on your estimated taxes The IRS will charge you the underpayment penalty if you fail to pay your entire estimated tax amount.

The penalty amount fluctuates, changing every quarter, and is decided as per the current interest rate. The interest adds up on unpaid balance and dues and compounds daily from the tax return's due date (regardless of any extension), until you pay the entire balance.

The Internal Revenue Service has increased the interest rates for the calendar quarter beginning April 1, 2022.

The revised rates are as follows:

  • 4% for underpayments
  • 6% for large corporate underpayments
  • 4% for overpayments (3% in case of a corp)
  • 1.5% of a corporate overpayment exceeding $10,000

What is the underpayment estimated tax penalty?

The IRS can slap you with this penalty, also known as an underpayment penalty, if you are unable to make the total estimated tax payments.

Underpayment penalty rate:

  • Usually in the case of a corporation, the underpayment rate is the federal short-term rate plus three percentage points
  • The rate for large corp underpayments is the federal short-term rate plus five percentage points

The IRS calculates the penalty based on:

  • Total underpayment amount
  • The interest rate for underpayments
  • The period when the underpayment was underpaid

IRS Interest Rates for Underpayments for Quarter 2 of 2022

Type of underpayment

Applies to

Rate

Compounded

Standard

Corporate and non-corporate underpayments

4%

Daily

Large corporate

Corporate underpayments > $100,000

6%

Daily 

How to avoid the underpayment estimated tax penalty?

  • The underpayment tax penalty can be avoided if the taxpayer owes less than $1,000 in tax after withholdings and credits
  • The other way to avoid the underpayment penalty is by paying a minimum of 90% of the tax you owe, or 100% of the tax shown on the return for the previous tax year
  • For example, if your tax bill for the previous year was $4,000, and this year you withheld $4,500, but your total income tax bill is $6,500, you won't have to pay the underpayment penalty because you withheld more than the last year's tax obligation
  • Let's assume you made estimated tax payments of only $2,000. This is approximately 31% of your tax obligation ($2,000 divided by $6,500) and is less than your prior year's income tax
  • Therefore, you'll have to pay the underpayment penalty unless you meet other criteria specified by the Internal Revenue Service. You can use FlyFin's tax penalty calculator to figure out your underpayment penalty

How does the penalty for underpayment work for quarterly taxes?

  • Once the due date has passed, the IRS will typically charge you 0.5% of the entire tax amount you owe
  • For each partial or whole month, you don't pay the tax in full, and the penalty increases with a cap of 25%.
  1. Penalties include interest, which may change quarter to quarter
    Listed above are rules of thumb that'll help you understand your potential penalty. However, the actual penalty fluctuates because it includes interest for missed payments, and the interest rate usually changes from quarter to quarter. The interest rate for Quarter 2 for the year 2022 is as follows:
  2. Penalties are calculated based upon specific quarters - not the year
    You may have paid the total amount due for a particular tax year but may still have to pay the underpayment penalty (for a specific quarter). Even if you overpay the entire year's quarterly taxes as a whole, you may still have to pay the penalty, so long as you were short for a particular quarter. If, for example, you skipped the April 15 payment deadline but pay extra in June to catch up on payments, you'll still have to pay the penalty for the April 15 estimated payment.

Other ways to avoid the estimated tax penalty

Using safe harbor rules:

  • The best and the most obvious way to avoid an estimated tax payment is to pay by the deadline and to pay exactly what you owe
  • The underpayment tax penalty can be avoided if the taxpayer owes less than $1,000 in tax after withholdings and credits
  • The other way to avoid the penalty for underpayment is by paying minimum 90% of the tax owed for the current tax year or 100% of the tax shown on the return for the previous tax year
  • However, these penalties won't be enforced if you resort to the safe harbor rules

The following table represents the conditions you'll have to meet based on your business's adjustable gross income (AGI) that'll help you resort to the safe harbor rules:

Adjustable gross income 

When won’t you have to pay the penalty

$150,000 or less

You paid 100% of last year’s tax liability in every quarter

More than $150,000 

You paid 110% of last year’s tax liability in all four quarters

For example, if your gross income for the prior year was $50,000, and it increased to $100,000 for the current tax year, you can make your quarterly tax payments based on $75,000, and you won’t receive a penalty. But you will need to pay tax for the extra $25,000 as a lump sum on April 15.

The annualized income installment method for freelancers with fluctuating income

It's not unusual for freelancers and self-employed individuals to earn loads of money in one quarter and very little the next. That can make estimated tax payments stressful.

The annualized income installment method can help make this situation easier. Using this method, you'll be able to figure out how much you are paying per quarter using Schedule AI. It can be found on page 3 of form 2210.

Penalty waiver

If you are able to prove that your underpayment was the result of a “reasonable cause” — such as a medical emergency or family death — you’ll most likely get a pass.

However, “willful neglect,” i.e., intentionally ignoring the payment, won't be acceptable by the IRS.

Who qualifies for an underpayment tax penalty waiver?

The IRS waives off underpayment penalties if you:

  • Became disabled
  • Experienced a disaster, casualty or other "unusual circumstance"
  • Are at least 62 years old and retired that year

Requesting a waiver of the tax penalty  

In order to request a waiver of penalty, you'll have to fill out Form 2210 and check the right box in Part II.

Box 

Type of waiver

A

Full waiver

B

Partial waiver

You'll have to submit the form along with a statement explaining why you weren't able to pay estimated taxes during the specific time period for which you are requesting the waiver.

You'll also need some documentation proving your reasons. Here are some examples of the documents you may attach as proof:

Reason for waiver

Documentation required

Casualty or disaster

Insurance company reports or police reports

Retirement

Proof of retirement date, proof of age

Disability

Disability insurance statements, hospital records

What to do if you can’t pay all your estimated quarterly tax at once

If you can’t arrange for funds, even if you know a deadline is approaching, don't wait until you can pay the whole amount. Try to pay as much as you are able by the deadline.

Even a partial payment lowers the penalty you’ll end up owing.

How can FlyFin help avoid penalties?

FlyFin uses A.I. to find every possible tax deduction in your business expenses and provides 24/7 CPA assistance. In addition, our CPAs ensure accurate tax filing, leaving no space for tax penalties.

The app also notifies you of upcoming tax filing deadlines, acting as an A.I.-powered alarm clock, so you never pay unnecessary penalties. Make sure to avoid future tax penalties with FlyFin.

FlyFin CPA Team

FlyFin CPA Team

With a combined 150 years of experience, FlyFin's CPA tax team includes tax CPAs, IRS Enrolled Agents and other tax professionals, offering users the most comprehensive tax advice and preparation.

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