Nobody likes to pay taxes, but the only thing worse than a whopping tax bill is owing an Internal Revenue Service (IRS) penalty on top of it. Sadly, millions of taxpayers end up having to pay extra amounts every year because they didn't know important information about the different tax penalties.
There's no justification for paying any tax penalty, because with careful planning and intention, you can avoid everything the IRS tries to throw your way. With that in mind, let's learn about common IRS tax penalties on the books and real-world guidance on how to avoid them.
Most common IRS tax penalties
Dozens of penalty provisions are baked into our tax laws, and they cover a wide variety of things. In some cases, simply failing to do something you were supposed to do is enough to trigger a penalty. In other cases there must be a real-dollar cost to the IRS before the federal tax collection agency hits you with a penalty.
The most common reasons for IRS tax penalties include the following:
- Failing to file your required tax return on time, meaning by the annual deadline known as Tax Day.
- Failing to pay your taxes on time.
- Failing to make estimated tax payments throughout the year, when required.
- Taking early withdrawals from IRAs, 401(k)s, or similar tax-advantaged retirement accounts.
- Taking nonqualified withdrawals from 529 plans, health savings accounts (HSAs), and similar tax-favored accounts.
- Filing a substantial incorrect tax return or taking frivolous positions on a return.
- Failing to take required minimum distributions (RMDs) from a tax-favored retirement account.
- Making excess contributions to tax-favored accounts like IRAs.
I'll detail each of these penalties in turn below, and point out how to reduce or eliminate penalties.
Penalty for failing to file
Many people who can't afford to pay their taxes make the major mistake of choosing not to file a tax return at all. They erroneously think that if they don't file, then the IRS won't have any way of knowing that they owed tax in the first place. Unfortunately, that's almost never true, as most taxpayers have employers who report their earnings to the IRS independently. If the IRS doesn't get a tax return from you but receives an information return from someone claiming to be your employer, then you can expect it to trigger an audit.
The IRS does its best to discourage failing to file a tax return by setting a high penalty on those who choose not to file. For each month or part of a month that you're late in filing, a 5% penalty is levied and added to your outstanding tax bill. That penalty hits a maximum of 25% within five months of the due date for your return. A separate minimum of $205 applies, although the penalty is never larger than your entire tax bill.
The best and easiest way to buy yourself some time to avoid the failure-to-file penalty is to file for a six-month extension before the original tax deadline in mid-April. That way you'll have until October 15 before the clock starts running on a failure-to-file penalty. Hopefully, that six-month grace period gives you enough time to prepare your return and send it to the IRS. As you'll see below, though, the extension doesn't get you off the hook if you can't pay your taxes.
Penalty for failing to pay
The reason you should file a tax return even if you can't afford to pay your taxes due becomes clear when you look at the corresponding IRS penalty for failing to pay your taxes on time. It's true that there's a penalty for not actually paying your taxes, but it's a lot smaller than the penalty for failing to file your tax return entirely.
For every month or part of a month that you're late in paying your taxes, you'll owe a penalty of 0.5% of your unpaid taxes. That's just a tenth of the penalty for failing to file a return in the first place. The same maximum 25% penalty applies, but it takes more than four years to reach that point.
Another key difference between failing to pay and failing to file is that requesting an extension for your tax return does not buy you any extra time to pay your tax. Taxpayers who request an extension are still required to make an estimate of their tax liability and to pay it before the original deadline, or else penalties start to run immediately thereafter.
If you're in a bind that really prevents you from being able to pay your taxes in a timely fashion, then there are alternatives.
Installment agreements allow you to get a predictable timeline by which to repay your tax debt, and although they won't necessarily stop penalties from accruing, they will make the IRS hold off on formal collection proceedings. Similarly, an offer in compromise involves a taxpayer making a deal with the IRS to pay down tax debt on a prearranged basis, looking at financial means and ability to pay. By turning to the government for help, you can often reach a much better result than you'd get by simply trying to lie low and having penalties imposed on your taxes.
Penalty for not making estimated tax payments
If you're like most people, the bulk of your income comes from your job, and because your employer withholds federal income tax from your paychecks, it's unlikely that you'll get yourself into trouble with this penalty, as long as your job is your primary income source.
However, many people get the lion's share of their income from somewhere other than a job. Retirees receive Social Security benefits and also withdraw money from their personal savings, including tax-favored retirement accounts for which withdrawals can be subject to tax and investment accounts subject to capital gains tax. Entrepreneurs who derive income from their business are subject to self-employment tax.
Without the same mechanisms for having taxes withheld as regular workers, it's up to these particular taxpayers to make estimated tax payments every quarter -- or else suffer the consequences in the form of a penalty.
The estimated tax payment system ensures that taxpayers pay the bulk of their anticipated tax liability regularly throughout the year. Using IRS Form 1040-ES, taxpayers can use their expected income to calculate how much they'll have to pay in estimated taxes throughout the year. The form then has you break out the total yearly amount into four quarterly payments, due on April 15, June 15, Sept. 15, and Jan. 15 of the following year. You don't actually have to file the 1040-ES, but it's important to keep it in your records in order to show that you complied with the estimated tax requirements.
For 2018, the penalty ranged from 4% to 5% on an annualized basis. For 2019's first quarter, the annualized penalty rate will rise to 6%.
The penalty is imposed on what you should have paid in estimated tax payments, so the solution is to make those payments on time. As long as you pay at least 90% of your current-year tax in your estimated tax payments, you'll avoid the penalty. You can also meet a safe harbor by paying 100% of your tax bill from the previous year in estimated payments, although those with income above $150,000 have to make payments totaling 110% of last year's tax bill to qualify for the same safe harbor. As long as your tax bill is less than $1,000, you also avoid the penalty, even if you wouldn't meet the percentage-based tests above.
Early-withdrawal penalties for retirement accounts
Tax-advantaged retirement accounts are extremely useful for long-term savings, and the IRS is protective of the intended purpose of those retirement accounts. That's why it imposes a 10% penalty if you take money out of your IRA or 401(k) early, with exceptions only for very special cases.
For most people, 59 1/2 is the age at which withdrawals from IRAs and 401(k)s become allowed without penalty. However, if you leave your job during or after the year in which you'll turn 55, then you're allowed to take withdrawals from a 401(k) account at that job with no penalty. A caveat: that earlier age does not apply to IRAs or to 401(k) accounts from employers other than your most recent one.
If you use withdrawals for permitted purposes, then the penalty is waived. Those allowed cases include up to $10,000 to go toward a first-time home purchase, medical bills that aren't covered by insurance and exceed 10% of your adjusted gross income, health insurance premiums after you've been unemployed for at least 12 weeks, or money to pay qualifying higher-education expenses such as college tuition, room and board, and required fees. Remember that even if the penalty is waived, you'll still typically have to pay regular income tax on the amount you withdraw from a traditional IRA or 401(k) account.
Withdrawal penalties for tax-favored accounts
Other tax-favored accounts are designed to serve specific purposes, and the IRS imposes penalties to try to keep people from using them improperly. In addition to the retirement accounts above, the following accounts have similar penalties:
- Health savings accounts (HSAs) are designed to help people who have high-deductible health insurance coverage set money aside to cover the healthcare costs their insurance policies won't pay. Withdrawals from an HSA that go toward qualifying healthcare expenses do not incur tax. But if you withdraw money before age 65 for nonmedical expenses, you'll owe a 20% penalty on the amount withdrawn -- as well as being required to include the withdrawal in your taxable income.
- 529 plans let people save for educational expenses, with a recent expansion allowing withdrawals to cover costs of K-12 education as well as traditional college costs. If you withdraw 529 money to cover eligible educational costs, then there's no penalty, and the amount withdrawn isn't subject to tax. However, if you take money out for purposes other than paying school-related expenses, you'll have to pay a 10% penalty on top of the income taxes resulting from adding the withdrawn amount to your taxable income for the year.
- Coverdell ESAs are another way to save toward college costs. They aren't as popular as 529 plans, because Coverdell ESAs have more restrictive contribution limits. But they are useful for those who want a wider range of available investments beyond the fixed menus offered by 529 plans. The IRS charges the same 10% penalty on withdrawals made for purposes other than paying qualifying educational costs.
In general, the best way to avoid penalties on these accounts is not to tap them for purposes other than the ones for which you set them up.
For educational accounts, one alternative is to change the beneficiary of the account. So if you have two or more children and it turns out that you've saved more money than your oldest child needs for college, you can change the beneficiary on the 529 account to a younger child without penalty. There are some exceptions to the penalty for scholarship recipients and similar situations, but they're limited in scope.
Penalties for filing incorrect, fraudulent, or frivolous returns
Everyone makes mistakes, and it's not uncommon to find errors on tax returns. For the most part, the IRS is relatively forgiving of simple unintended errors. But it does retain the legal right to impose penalties in various situations, and some of the penalty amounts can be jaw-droppingly high.
The penalty amount is different depending on whether you deliberately tried to underpay your taxes or you simply made a mistake. If you mistakenly claim a refund or tax break on your return, the IRS can impose a penalty of 20% of the amount of tax underpaid as a result of the improper claim. This typically applies when the taxpayer's mistake is serious enough to constitute legal negligence, or if the size of the underpayment is large enough to be substantial.
If you intentionally understate your tax bill, more serious penalties apply. The penalty for civil fraud is 75% of the amount underpaid, on top of that original amount itself. Moreover, certain common arguments for trying to get out of paying taxes are so unfounded that the IRS considers them frivolous tax arguments. Users of those strategies can end up having to pay a flat-rate penalty of $5,000 regardless of the amount of tax owed.
At the most serious end of the spectrum, activity that rises to the level of tax evasion or criminal fraud can face both monetary penalties and potential imprisonment. The line between criminal tax evasion and civil tax fraud isn't always clear, but if federal authorities can establish beyond a reasonable doubt that you intended to try to get out of paying taxes in a serious enough way, the penalties can be severe. Tax evasion or perjury on a return can carry years of jail time as well as six-figure fines, so it's important not to take your taxes lightly.
Penalty for not taking RMDs from retirement accounts
One thing many retirees don't know is that there comes a time when you absolutely must start taking money out of your retirement accounts like traditional IRAs and 401(k)s.
For most people, the age that triggers these required minimum distributions (RMDs) is 70 1/2. The amount of the RMD is calculated based on the value of your retirement account and your life expectancy, according to IRS tables. The intent of the RMD provisions is to put a limit on the length of time you can set money aside on a tax-deferred basis, and to give the government its bite of your income that has long been gaining growth in its tax-advantaged shelter.
To enforce the rules governing RMDs, the IRS imposes a draconian penalty on those who fail to comply by withdrawing their required amount by the deadline. If you don't take your RMD by Dec. 31 -- or April 1 for the first year in which you're required to take withdrawals -- you'll owe a whopping 50% penalty on the amount that you were supposed to withdraw. If you do take a distribution, but it isn't enough to satisfy the RMD requirement, the 50% penalty applies to whatever the shortfall was. So if your RMD was really $2,000 and you took out only $1,500, your penalty would be calculated on the $500 difference.
Calculating your RMD can be complicated, as it requires that you take the value of your retirement accounts as of the end of the previous year and then use a life expectancy factor to determine what portion of the total value you're required to withdraw. The amount changes every year based on the fact that you're a year older and that the value of your retirement accounts changes. The idea, though, is to have your retirement account assets distributed regularly over the course of your lifetime.
Fortunately, most financial institutions will help you work out the proper amount, and some will even let you arrange to have the money taken automatically out of your account at regular intervals. The prospect of losing half your money to an IRS penalty is ample incentive for most taxpayers to get the job done right.
Penalty for contributing too much to tax-favored accounts
In a similar vein, the IRS also frowns upon contributing more than you're allowed to an IRA or 401(k). Your employer will typically prevent you from overcontributing to a 401(k), but IRAs are easier to make mistakes with, especially if you have multiple retirement accounts at different financial institutions.
At 6%, the penalty for overcontributing to a retirement account is much less than the penalty for failing to take an RMD. However, the important thing to remember with the excess contributions penalty is that it applies every year until you take out that extra amount. So theoretically, if you overcontributed to an IRA 10 years ago and have only now noticed the problem, you could face 10 years' worth of 6% annual penalties.
To rectify this situation, remove the extra cash before the deadline, or extended deadline, for the tax return for the taxable year in question. That typically gives you until mid-October of the following year to fix a problem in any particular tax year. Similar taxes apply to other types of accounts, such as HSAs. The solution is the same: take the extra amount out as soon as possible.
Don't pay penalties you don't have to pay
Nobody likes paying tax penalties, and knowing about them is the first step to avoiding them altogether.
Even if you end up with a tax penalty problem, there are ways to reduce or eliminate it. The more you know, the more likely it is that you'll be able to escape IRS tax penalties and take future action never to face them again.
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