- Penalties for underpaying estimated taxes have increased as the Fed has raised interest rates
- The penalty was 8% as of October 1, down from the lowest possible level of 3% in early 2021
- The penalty applies primarily to self-employed people who pay taxes quarterly
The IRS penalty for underpaying estimated taxes has risen sharply this year, with self-employed and freelancers most at risk of being hit.
The penalty, calculated quarterly based on the Federal Reserve’s key interest rate, reached 8 percent on Oct. 1, up from just 3 percent in early 2021 when Fed rates were near zero.
The penalty rate applies to understatements of the estimated taxes that self-employed individuals pay the IRS quarterly based on their income for the period in question.
Employees whose income taxes are deducted from their pay generally do not have to pay estimated taxes and are unlikely to be affected by the new penalty.
But for the self-employed, the new higher penalty is another consequence of the Fed’s aggressive interest rate hikes, with which the central bank is fighting inflation.
The IRS penalty for underpaying estimated taxes has risen sharply this year, with self-employed and freelancers most at risk of being hit (stock image)
The IRS calculates the underpayment penalty by taking the Fed funds rate for the quarter and adding 3 percent.
According to the Wall Street Journal, the IRS imposed more than $1.8 billion in penalties for underpaying estimated taxes on nearly 12.2 million individual tax returns in fiscal year 2022.
The IRS expects workers to pay taxes on the side, whether through withholding from paychecks for employees or through quarterly payments for self-employed people.
These rules apply for the relevant period. This means that you can be penalized for underpaying estimated taxes for a single quarter, even if you pay more than is owed for the entire year.
According to the IRS, you can avoid an underpayment penalty if your filed tax return shows you owe less than $1,000.
The underpayment penalty, which is calculated quarterly based on the Federal Reserve’s key interest rate, reached 8 percent on October 1, up from just 3 percent at the start of 2021
In addition, anyone who pays at least 90 percent of their debts for the tax year in question or 100 percent of their debts in the previous year is granted penalty protection.
Not every freelancer has to pay estimated taxes.
If you pay federal tax withholding through an employer and have a small freelance side job, you generally don’t have to pay estimated taxes each quarter.
The deadline to pay estimated taxes for the final quarter of 2023 is January 15th. However, if you file your 2023 tax return by January 31 and pay all taxes owed for the year, this deadline does not apply.
Estimated taxes can be paid through the IRS website at IRS.gov.