Over the past year, the IRS has significantly increased penalties on underpayment of both estimated tax payments and federal income withholding from salary and retirement income. Individuals who are required to make quarterly estimated payments (due dates each year are April 15, June 15, September 15 and the following January 15) include those individuals with large amounts of investment income such as interest, dividends and capital gains that is not subject to federal income tax withholding. Also included among individuals who should consider making estimated tax payments are retirees who have no or little federal income tax withholding from their pension income. There are federal employees with sizeable amounts amount of investment income who are paying too little or no federal estimated tax payments. There are also federal retirees who have too little federal income tax withheld from their CSRS or FERS annuities and /or Thrift Savings Plan (TSP) withdrawals and who are paying too little or no federal estimated tax payments.
IRS penalties for an employee not having a sufficient amount of federal income taxes withheld from salary or paying an insufficient amount of estimated tax payments can be significantly large. Making the required amount of estimated tax payments can save employees and retirees hundreds of penalty dollars each year.
According to the IRS, the average federal estimated tax payment penalty during the year 2023 increased to about $500 from about $150 during 2022. Meanwhile, the number of affected individual tax filers subject to underwithholding penalties increased to 14 million during 2023 from 12 million during 2022. Overall, the IRS assessed $7 billion in estimated tax penalties in 2023, nearly four times the 1.8 billion it assessed during 2022. A key reason for the increase of almost four-fold in the dollar amount of penalties is the higher interest rate the IRS charged during 2023 compared to 2022.
To understand why the interest rate matters with respect to underwithholding penalties, it is important to remember that since 1943 when Congress expanded the federal income tax during World War II, employees have had to pay their annual federal income tax liability through salary withholding. To prevent any “gaming of the system”, IRS rules require individuals with taxable income that is not subject to withholding, (for example, investment income or net rental income) to make quarterly federal estimated tax payments.
Individual tax filers who do not pay in a sufficient amount of federal income tax throughout the year owe a penalty in the form of an interest charge on the amount of their underpayment (the interest charge is set quarterly by the IRS).
For 2021 federal income tax returns filed during 2022 (the year that started an increase in underpayment penalties) the IRS interest rate on underpayments was 3 percent. The rate increased to 6 percent in early 2023, and resulted in increased penalties for 2022 federal income tax returns filed during 2023. In late 2023, the interest rate rose to 8 percent.
For individual tax filers trying to avoid underwithholding penalties, the bad news is that the penalties are hard to avoid without a thorough knowledge of the tax rules. The following explanation should help federal employees and retirees better understand these rules.
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The Basics of the Federal Income Tax Underwithholding Penalties
IRS rules state that individuals who owe $1,000 or more at the time they file their annual federal income tax return, must pay 90 percent of their federal tax liability before the April 15 due date. For employees who fulfill their federal tax liabilities only through payroll withholding, the deadline for paying the 90 percent is December 31 preceding the April 15 deadline. For those individuals who have other taxable income not subject to withholding, the deadline for paying the minimum 90 percent is the fourth quarter federal estimated tax payments deadline of January 15 preceding the April 15 deadline.
If individuals do not pay in the minimum 90 percent, and are not protected by “safe-harbors” (discussed below), they can owe an interest charge assessed on the amount of the underpayment. The interest rate is set and published by the IRS. Currently the interest rate is 8 percent.
Individuals who make a payment to the IRS via an estimated tax payment during the year can reduce these interest charges.
Beware of the Dangers of “Safe Harbors”
Some individuals are aware of “safe harbors” that protect against estimated tax penalties. In particular, if an individual whose prior year adjusted gross income was less than $150,000 and who pays the IRS 100 percent of their prior year federal income tax liability by December 31 or January 15 fourth quarter estimated tax payment deadline, then there could be no underwithholding tax penalty. Individuals whose prior year adjusted gross income exceeded $150,000 must pay 110 percent of their prior year federal tax liability by the deadline in order to qualify for the waiver of an IRS underwithholding penalty.
However, individuals need to be aware that the above “safe harbors” apply per quarter, not per year. That means if an individual has significant taxable income during the second quarter of the year (April 1- May 31) but does not pay the “safe harbor” amount for that second quarter (equal to 100 percent of the prior year second quarter federal income tax liability) until the third or fourth quarter, an underpayment penalty could apply.
Extra Federal Income Tax Withholding Can Help
Some individuals, and this includes retirees, have taxable income that qualifies for withholding when the income is paid as well as having income that is not subject to federal income tax withholding (but whose tax liability should be paid via estimated tax payments). For federal retirees, this taxable income includes CSRS and FERS annuities, Thrift Savings Plan (TSP) withdrawals, traditional IRAs withdrawals, and Social Security payments.
Extra federal income tax withholding on this taxable income has a terrific benefit. IRS rules consider withholding on this income to have to have been paid “evenly throughout the year”, no matter when the extra federal income taxes were withheld, resulting in minimum or no IRS underwithholding penalty. The following example illustrates:
Richard owes $5,000 of federal income taxes on investment income that occurred during the first quarter of the year. In December, Richard made a traditional IRA withdrawal and requested an extra $5,000 in federal income tax that covers the $5,000 in federal income tax due during the first quarter of the year. The extra $5,000 withdrawal should avoid the estimated tax penalty for the first quarter of the year.
Note that since it is sometimes challenging to request extra withholding from Social Security payments and from federal retirement annuities (CSRS and FERS annuities), it is often easier for IRA custodians and the TSP to fulfill the extra federal income tax withholding request from traditional IRA and TSP withdrawal.
Do Not Forget about State Estimated Tax Penalties
States in which there are state and local income taxes – 42 states and the District of Columbia – often have penalties on underpayments of estimated income taxes and state income tax withholding. Individuals living in one of these states should check with their tax advisor in order to see where they stand with respect to state estimated tax penalties and how to avoid or at least minimize the penalties.
Federal employees and retirees who have problems and questions about requesting additional federal income tax withholding and/or the need to make federal estimated tax payments should consult with a qualified and knowledgeable tax professional.
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Ed Zurndorfer, EA, ATA, CFP®, CLU®, ChFC®, CEBS®, ChFEBC℠: Federal Employee Benefits Expert
A former career Federal employee, Ed has published a staggering 1,200+ separate articles on Federal Benefits and Retirement!
Just “Google” his name, and you are likely to find a plethora of sites that contain his writings. Drawn to its mission to reach, teach
and serve Feds, Serving Those Who Serve is the only financial planning practice with which Ed has chosen to affiliate in over
20 years teaching. In addition to conducting Federal Benefits seminars for Serving Those Who Serve, you can find Ed’s
writings here on our blog in the FedZone, and on Fed-Soup, MyFederalRetirement, FederalNews Radio and NITP.
He is a member of the Maryland Society of Accountants, the National Association of Enrolled Agents, the International Society of Certified Employee Benefits Specialists, the Financial Planning Association, the National Association of Health Underwriters,
and the Society of Financial Service Professionals. Since 1999, Ed has taught many thousands of Federal employees about
their benefits, in person and at Federal agencies all over the country. Ed is a true national treasure.
Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street - Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
