What it means
Tax systems are designed to collect money steadily through the year and not in one lump sum at the end. Employees have tax withheld from each pay cheque.
People with other income, such as self-employed workers, landlords and investors, usually must make estimated payments in instalments. If the payments are too low by the due dates, the authority charges a penalty on the shortfall for the period it was unpaid.
The rate is set by the tax authority and adjusts over time, so it should be checked each year rather than assumed. The penalty is calculated separately for each instalment period.
There are ways to avoid the penalty through what are often called safe harbours. Typically, you avoid it if you pay a set share of the current year's tax, or a set share of the prior year's tax, through withholding and estimated payments.
Higher earners may face a higher percentage test, and exceptions exist for certain situations such as a first year of business, so confirm the current rules. For businesses, the penalty is a reminder that tax is a cash flow item that needs forecasting.
A profitable year, a large bonus, the sale of an asset or a change in income pattern can create a surprise liability. Setting aside cash each month and revisiting the forecast every quarter helps avoid it.
The penalty is not usually large compared with the tax itself, but it is a pure waste of money. It is also a sign that tax planning is not keeping pace with the business.
Many advisers recommend adjusting withholding or estimated payments as soon as income changes. Some taxpayers use an annualised income method, which matches the required payments to when income was actually earned.
This can help those whose income is uneven, such as seasonal businesses or people who sell an asset late in the year. It takes extra paperwork, but it can remove or reduce the penalty.
In practice
Real-world examples.
Example
A freelance consultant has a strong second half of the year and earns $60,000 more than expected. She had made estimated payments based on the first half, so she is short at the later due dates. A quick recalculation in September would have avoided the penalty. She now reviews her income each quarter.
Example
A landlord sells a property and realises a gain of $150,000 in November. He did not adjust his estimated payments, so the authority charges a penalty for the shortfall from the earlier due dates. His adviser shows him how to use an annualised income method to reduce the charge.
Example
An employee takes a second job and forgets to update her withholding. At the end of the year, her tax bill is $3,200 higher than what was withheld, and she pays a penalty on the shortfall. She submits a new withholding form for the next year. Her employer adjusts each pay cheque from then on.
Formula
Calculation
Penalty = Underpayment x Annual penalty rate x (Days underpaid / 365)
A taxpayer should have paid $10,000 by a due date but paid only $6,000, so the underpayment is 10,000 - 6,000 = $4,000. For this illustration assume an annual penalty rate of 8% (the real rate is set by the tax authority and changes over time). The shortfall stays unpaid for 73 days. The penalty is 4,000 x 0.08 x (73 / 365) = 320 x 0.20 = $64.Case study
Seen in the real world.
Oakhaven Design is an illustrative, fictional two-person studio whose profits tripled in a year after winning a large contract. The partners continued to make estimated payments at the old level because they had set up automatic transfers the year before.
When the accountant prepared the tax return, she found an underpayment of $24,000 spread across the last three instalment dates. The penalty came to about $600, which the partners found annoying because they had the cash available all along.
The illustrative lesson was to review estimated payments each quarter. Oakhaven now compares year-to-date profit with the plan, updates the payment amount whenever profit moves materially, and keeps a tax reserve account that is topped up with each client payment.
Watch out
Common mistakes.
- Believing that paying the full bill by the filing deadline avoids the penalty, when the charge depends on when each instalment was paid.
- Basing estimated payments on last year's income without checking this year's results.
- Assuming the penalty rate is fixed, when it is set by the authority and can change.
Questions
People also ask.
How can I avoid an underpayment penalty?
Pay enough through withholding and estimated payments to meet a safe harbour, such as a set share of this year's tax or of last year's tax, and check the current percentages.
Can the penalty be waived?
In some situations, such as a disaster or retirement after a certain age, the authority can waive or reduce it, but you usually have to request this.
Is the penalty tax-deductible?
Penalties and interest charged by a tax authority are generally not deductible, but confirm the position with your adviser.
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