Unforced Errors - The 8 Most Common IRS Tax Penalties and How to Avoid Them
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 2020 is set to be penalized on an annualized basis of 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 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.
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 An 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. The experienced tax accountants with ProTax Service are available to guide you through the process of successful tax preparation each and every time. Please call ProTax Service at (310) 869-0038 for assistance.