You know the old line about the inevitability of death and
taxes? It’s still true. What isn’t inevitable, however, is the need to pay
penalties to the IRS. It happens, but it doesn’t have to, and the main reason
that it does is because taxpayers don’t educate themselves about the rules.
When you get hit with an IRS penalty, it adds on to a number
that you already wish you didn’t have to pay.
To ensure that you get through tax season without unnecessary costs and
aggravation, here’s a list of the tax penalties that the IRS most frequently
assesses against taxpayers.
The 8 Most Common Tax Penalties Assessed
- Penalty for underpaying estimated tax payments
- Penalty for taking early withdrawals from tax-advantaged retirement accounts, including IRA accounts and 401(k) accounts
- Penalty for taking nonqualified withdrawals from 529 plans, health savings accounts (HSAs), and similar tax-favored accounts
- Penalty for failing to take required minimum distributions (RMDs) from tax-favored retirement accounts
- Penalty for making excess contributions to IRAs and other tax-favored accounts
- Penalty for failing to file, or for filing your required tax return after the designated due date
- Penalty for failing to pay your taxes on time
- Penalty for filing a substantially incorrect tax return or taking frivolous positions on a return
Let’s take a deep dive into each. The more you know, the better
you’ll understand how to avoid these mistakes.
1. Penalty for not making estimated tax payments
Where does your income come from? If you’re a W-2 employee whose employer
withholds your federal income tax on your behalf, then estimated tax payments
are not something you need to worry about. On the other hand, if you get income
from which withholding isn’t deducted, then you are legally obligated to submit
estimated quarterly tax. Failure to do so is subject to penalty.
Who has to submit quarterly estimated taxes? You do if you’re a part of
the “gig” economy which
makes part or all of your income from freelance jobs or independent contracting
work, or if you’re a retiree who relies on or derives income from Social
Security and your personal savings accounts or other accounts whose withdrawals
are taxable (or subject to capital gains). Own a small business? If
you’re subject to self-employment tax, then you’re supposed to submit it
quarterly. Though this requirement is straightforward, most people start their
income journey as W-2 employees: they may have no familiarity with estimated
quarterly taxes, or if they do they may not be in the habit of paying it and
have forgotten. Whatever the reason, the penalties for failure to make these
payments can add up pretty quickly.
The government has set up the quarterly payments so that the IRS Form 1040-ES
is marked with four dates throughout the year — April 15th, June 15th,
September 15th and January 15th (or the next business day if the 15th falls on
weekend or legal holiday) of the year that the year’s tax filing is due. In
doing so, they have it set up so that the majority of the taxes that are owed
are paid throughout the year, though not on a weekly, biweekly or monthly basis
the way that W-2 employees withholding is sent in. Failing to send the monies
in for each quarter of 2018 is set to be penalized on an annualized basis of 4
to 5 percent. The best way to avoid the penalty is to pay your taxes on the
dates that they’re due, calculating the payments accurately enough to represent
either 90 (85% for 2018) percent of the actual amount you end up owing or 100%
of the amount that was appropriate from the previous tax year. That 100% of the
previous year’s amount is acceptable under what is known as safe-harbor, though
for those whose income is more than $150,000, the percentage needed is 110% of
the previous year’s income tax. Conversely, those who owe less than $1,000 in
annual taxes do not get penalized at all. It is important to note that the
penalty percentage has jumped to 6 percent as of the first quarter of
2019.
2. Penalty for taking early withdrawals from tax-advantaged retirement
accounts, including IRA accounts and 401(k) accounts
Having a retirement account is a smart thing to do, and it’s something that the
government has encouraged by allowing for the creation of special
tax-advantaged vehicles. These tax advantages represent a tremendous incentive
and benefit, but they come with strings: until you are 59 ½, you are not
permitted to take money out of those accounts prior to retirement without
having to have to pay a hefty 10% penalty.
As important as it is to know about the penalty so that you don’t take money
out hastily and without a full understanding of the impact of doing so, but
it’s also important to know when you can take the money out without being
penalized. You’re permitted to take out up to $10,000 from and IRA for the
purchase of a first home, as well as to pay any uncovered, unreimbursed medical
bills that add up to more than ten percent of your adjusted gross income from
any retirement plan. If you’ve been out of work and received unemployment
compensation for a minimum of 12 weeks, you can take out up to $10,000 from and
IRA to pay for your health insurance premiums. Distributions can also be
taken from an IRA to pay for qualified higher education expenses, including
fees, room and board and of course tuition, all without penalty. And if you’re
leaving your job during the same year that you’re turning 55 or older, you can
take money out of a 401(k) account from the job that you’re leaving without
penalty. The fact that there is no penalty does not negate the income taxes
that you would be required to pay on withdrawals from any retirement account.
3. Penalty for taking nonqualified withdrawals from 529 plans, health
savings accounts (HSAs), and similar tax-favored accounts
Just as the government works hard to make sure that the retirement accounts
they’ve allowed to be tax-advantaged are used as intended, they take a similar
approach to other tax-advantaged accounts, penalizing improper use and
withdrawals from 529 plans, health savings accounts, and similar
vehicles.
- 529 plans – These plans
provide the ability to set aside funds to pay for the cost of college, and were
expanded under the recent tax reform act to also allow for funds to grow
tax-free for eligible expenses for K-12 education too. Any money that is
deposited into a 529 can be withdrawn without penalty as long as the money is
going to pay for tuition, books and similar school-related expenses, but if the
money is withdrawn for any other purpose, the withdrawn amount is subject to
both income taxes on appreciation and a 10% penalty on the entire distribution.
One important thing to note: if you have set up a 529 in one child’s name and
wanted to use the monies for another child, that is not subject to penalty as
long as you change the beneficiary. The same is true for Coverdell ESAs.
- Health Savings Accounts (HSAs) – These plans were created to assist with the payment of out-of-pocket healthcare expenses. Money deposited into those accounts can grow to be withdrawn tax free as long as they are used for eligible costs; however, if you’re under the age of 65 and you use any of those funds for nonmedical expenses, the withdrawn amount will be subject to a 20% penalty and will also need to be reported on your tax return as income.
4. Penalty for failing to take required minimum distributions
(RMDs) from tax-favored retirement accounts
If you are a person who has been dedicated to putting money into your 401(k),
your IRA, or another retirement account, then the idea of taking money out
before you feel like you need it will just feel wrong. Unfortunately, the
government requires that you do so once you hit a certain age. The IRS’ rules
say that once you are 70 ½ you have to take what is known as a required minimum
distribution, a percentage that is based on a published table that factors in
your life expectancy and how much your account holds. As much as you might want
to let your money continue to grow, the government wants to limit the amount of
tax-deferred growth that each taxpayer can realize and start claiming its
portion of the money you’ve been keeping it from taxing: that’s the reason for
the requirement.
No matter how much you’d prefer not to touch your principal, the IRS takes an
aggressive approach to make sure that you do so: the penalty for failure to
take the amount out on the government timetable is more than significant – it’s
50% of the amount that you were supposed to take out, and if you don’t take out
the right amount then you’re going to have to pay half of whatever you should
have taken out but didn’t. The annual deadline is December 31st, though for the
first year that you owe you have until April 1st to take the withdrawal. Not
only do you have to make sure that you make your payment on time, but you have
to calculate it correctly, and that can be somewhat complicated because the
amount changes each year as your life expectancy and the value of your account
shift. The good news is that the bank or investment company where you’re
holding your money is generally equipped to assist with the calculation, and
can even make things easier by arranging for automatic dispersals. Setting this
up makes a lot of sense, as it eliminates the emotional twinge of writing a
check and makes sure that it gets done so you can avoid that draconian penalty.
However, the IRS does have the power to waive the penalty if you can show
reasonable cause for failing to take the distribution and have a made a
corrective distribution before applying for a penalty waiver.
5. Penalty for contributing too much to tax-favored accounts
Have you ever heard the phrase “they get you coming and going?” It may have
been written for the IRS. Just as you’re learning that they’ll penalize you for
not taking out enough money, you find out that they’ll also penalize you for
depositing too much. Tax-deferred accounts like IRAs and 401(k)s limit the
amount that you can contribute each year, and if you end up putting in too
much, you’re going to be hit with a 6% charge. Though that penalty is a
significantly lower percentage than is imposed for not taking the annual
required minimum distribution, the amount can grow over the years if it isn’t
addressed: if you make the mistake of leaving the excess funds in the account,
you’ll face the same penalty each year until it’s been withdrawn. That can add
up quickly, especially if you aren’t aware of the mistake you made until the
government hits you with the penalty several years later.
The solution is to review the amount that you’ve deposited to make sure that
there is no overage, and if there is to take it out before the deadline for
your tax return. If you’ve filed an extension, then you’ve also extended the
deadline for the withdrawal. This penalty applies to all tax-deferred accounts
that limit the amount of money you can deposit in a given year.
6. Penalty for failing to file, or for filing your required tax return after
the designated due date
The tax deadline is set in stone every year. It’s in the news; it’s on the IRS
website and your tax forms. There’s no escaping it, and if you try, then you’re
going to get penalized. Some people miss the deadline because they are
procrastinators or they just forgot, while others make the mistake of thinking
that if they don’t send in paperwork, then they won’t have to pay. Whatever the
reason, you’re going to end up getting caught one way or another and having to
pay the penalty. Those who run on the idea of “if I don’t send them my name and
income then they’ll never know that I owe them money” fail to realize that the
entity that provided that income also is required to send in paperwork to the
government. When there is no tax return filed to match the tax information
filed by your employer or investment, the government is going to begin an
audit, and you’ll be in far bigger financial trouble than you would have been
if you’d filed a return and let the government know that you couldn’t afford to
pay what you owe. Failure to file results in penalties that add up quickly:
4.5% of the tax due will be assessed and added to your tax liability for each
month that you’re late, up until you pass the five-month mark and hit the
maximum penalty of 22.5%. There is also a minimum penalty amount of smaller of
$210 or 100% of your tax due where it greater the percentage amount.
7. Penalty for failing to pay your taxes on time
In all fairness, some people don’t file their tax return because they don’t
have the money available to pay what they owe. The truth is that the amount
that is penalized for failing to file is much more than what you would be
penalized if you did file without paying. Though you’re looking at a penalty
one way or another, it makes sense to file, even without sending in the money
that you owe.
We’ve already gone over the 4.5% monthly penalty for failure to file, up to a
maximum penalty of 22.5%. On top of the failure to file penalty, there is 0.5%
penalty per month for failure to pay to bring the total penalty for failing to
file and pay for the first five months to 5% per month. However, If you get
your paperwork on time without actually sending in a payment, you avoid the
4.5% late filing penalty. Even after the first 5 months, the late payment
penalty continues to accrue until the tax is paid. One important thing to
remember is that the requirement to pay begins on the tax due date – even if
you request an extension for filing your return, the clock starts ticking on
the non-payment penalty on the tax deadline date. If you’re at all able to send
in money, then do so – even if it’s only a portion of what you owe.
For those who are suffering from financial difficulties, the IRS offers installment arrangements to
make things easier. Though penalties are still likely to be tacked on to your
tax liability, setting up an arrangement will prevent you from getting into
arrears with the government and stop them from initiating a collection action.
There are also negotiations available for those who provide proof of their
inability to pay. The government is willing to help and does help many
taxpayers, offering compromises where appropriate. You’re much better off
coming forward, submitting all necessary paperwork on time, and asking for
help.
8. Penalty for filing a substantially incorrect tax return or taking
frivolous positions on a return
The IRS understands that mistakes happen: people have trouble with mathematical
calculations or misunderstand definitions, and when that happens, and they
discover the errors, they generally send out a letter notifying the taxpayer of
their mistake and are open to hearing explanations. Sometimes they forgive the
mistake and allow a correction to be made, and in other cases, they impose a
penalty, usually no more than 20% of the underpayment for innocent errors. When
the penalty is that high, it’s generally an indication that the government has
reason to believe that the mistake represents legal negligence. It can also be
a reflection of the magnitude of the underpayment, with larger underpayments
resulting in more significant penalties.
However, none of these penalties are as significant as what you will face if
the government has reason to believe that your underpayment was
intentional.
Purposely understating the information on your tax return to minimize your
liability constitutes civil fraud, and subjects you to 75% penalties of the
amount that you underpaid. Of course, you will also still be on the hook for
the amount that you should have paid in the first place if your tax return had
been accurate and reflective of your real income. The IRS has little patience
for either fraud or for what they refer to as frivolous tax arguments meant to
help people evade paying what they owe. Depending upon the individual
situation, some taxpayers are penalized with no concern for the amount that
they actually owed and are required to pay a flat rate of $5,000.
These penalties are what results from civil fraud, but that is not the worst
penalty you can face. The IRS has the right to charge a person who perpetrates
significant underpayment or tax evasion as a criminal fraud subject to jail
time in addition to economic penalties. Where the line between civil tax fraud
and criminal tax evasion is drawn is subjective but assume that when the
government can prove that you purposely tried to get out of paying what you
owe, you’re going to be held accountable in a way that’s going to hurt. Lying
on a return is considered a form of perjury, and there are plenty of tax
evaders who have been forced to spend years in jail and to pay hundreds of
thousands of dollars in penalties.
IRS Penalties Are A Entirely Preventable Problem
Though the list of penalties provided here is not exhaustive, it gives you a
good idea of where you can get into trouble, as well as how to avoid trouble.
Learn the requirements, follow them, and when in doubt, seek help. It’s also
important to know that if you do get yourself into trouble, you’re much better
off facing your situation then trying to pretend they don’t exist. A tax
professional will guide you through the process and help you find your best
answers.
